Intermediate Financial Management (with Thomson One)

See IFM9 Ch26 Tool Kit.xls
for details.
See IFM9 Ch26 Tool Kit.xls
for details.
Table 26-3 shows Tutwiler’s projected post-merger cash flows, taking into
account all expected synergies and maintaining a constant capital structure. Both
Caldwell and Tutwiler are in the 40 percent marginal federal-plus-state tax
bracket.
Lines 1 through 5 of the table show the operating performance that Caldwell
expects from the Tutwiler subsidiary if the merger takes place, with Line 5
showing the earnings before interest and taxes (EBIT) for each year. Line 6 shows
taxes on EBIT based on Caldwell’s 40 percent tax rate, and Line 7 is the resulting
net operating profit after taxes (NOPAT).
Some of Tutwiler’s assets will wear out or become obsolete, hence must be
replaced. In addition, Caldwell plans to expand Tutwiler should the acquisition
occur. Therefore, Tutwiler must make investments in net operating capital each
year as shown in Line 8. Subtracting the required investments from NOPAT
results in free cash flow (FCF) as shown on Line 9. 12 This, in addition to the
WACC calculation in the next section, provides enough information to apply the
corporate valuation model.
In order to apply the APV model, we also need projected interest expense so
that the tax shields can be projected. Line 13 shows the expected interest expense
in each year, and Line 14 shows the interest tax shield, calculated as
Tax shield (Interest expense)(Tax rate) | 26-7 |
To apply the FCFE model, we also need the projected changes in the debt
level. Line 19 shows the projected debt levels; see the Web Extension for details
regarding the projection of debt and interest expense. The expected net change in
debt from year to year appears in Line 20. FCFE is calculated in Line 21 as FCF
(Line 9) Interest expense (Line 13) Interest tax shield (Line 14) Change in
debt (Line 20). See the Tool Kit for this chapter for details about how the pro
forma statement was constructed.
Table 26-3 projects only five years of cash flows, but Caldwell actually plans
to operate the Tutwiler subsidiary for many years—perhaps forever. We assume
that beyond our five-year horizon FCFs will grow at a constant rate and the capital
structure will remain stable. Based on these assumptions we can use the constant
growth formula to find the present value of cash flows beyond the Year 5
horizon as shown in note c of the table.
Of course, the post-merger cash flows are extremely difficult to estimate,
and in merger valuations, just as in capital budgeting analysis, sensitivity, scenario,
and simulation analyses should be conducted. 13 Indeed, in a friendly
merger the acquiring firm would send a team consisting of literally dozens of
financial analysts, accountants, engineers, and so forth, to the target firm’s headquarters.
They would go over its books, estimate required maintenance expenditures,
set values on assets such as real estate and petroleum reserves, and the
like. Such an investigation, which is called due diligence, is an essential part of
any merger analysis.
12 An equivalent calculation for FCF is to take NOPAT and add back in depreciation, resulting in operating cash flow.
Then subtract the increase in gross operating capital to calculate free cash flow. See Chapter 7 for more discussion on
free cash flow and how the two calculations are the same.
13 We purposely kept the cash flows simple in order to focus on key analytical issues. In actual merger valuations, the cash
flows would be much more complex, normally including such items as tax loss carryforwards, tax effects of plant and
equipment valuation adjustments, and cash flows from the sale of some of the subsidiary’s assets.
Chapter 26 Mergers, LBOs, Divestitures, and Holding Companies • 911