Sheet1ANALYSIS FOR FINANCIAL MANAGEMENT10th EditionRobert C. HigginsSuggested Answers to Additional ProblemsChapter 9Dynatech Inc.5-year Financial Projection($ millions)201020112012201320142015Income statementNet sales$243$257$321$386$443$461Cost of sales9598116135155161Gross income148159206251288300Depreciation5892124149120110Interest expense19172222144Operating expenses262428375467Net income before tax45273243100119Provision for taxes251721254548Net income after tax$39$27$33$40$70$75Balance sheetCash and securities41$11$13$16$18$19Accounts receivable252526323638Inventory474750566567Other current assets181517202525Total current assets13297107124144149Gross property and equipment5116128269911,0511,093Accumulated depreciation102160284433553663Net property and equipment409452542559498430Goodwill129129129129129129Total assets670678778812772708Accounts payable12911131415Short-term debt545462656218Current portion long-term debt555444Accrued expenses101213162020Total current liabilities8180919710057Long-term debt20118123421797(0)Deferred taxes404245515861Shareholders' equity348375407447517591Total liabilities and equity$670$678$778$812$772$708a. Estimate Dynatech's free cash flow from 2011 through 2015.Earnings before interest and taxes445465114123Tax rate64.0%66.1%59.0%44.5%40.3%EBIT(1-tax rate)1618276373Depreciation92124149120110Capital expenditures1012141655942Working capital109768396110115Change in working capital(34)713154Free cash flow$40$(79)$(3)$109$137b. Estimate the present value of Dynatech's free cash flow for the years 2011 - 2015. Amalgamated's WACC is 7.4 percent. Dynatech's WACC is 11 percent, and the average of the two companies' WACCs, weighted by sales, is 7.6 percent.PV@ 11% {FCF, 2011-2015} =$123.08The fundamental principle is that the discount rate should reflect the risks of the cash flows discounted. Here, the cash flows are Dynatech's, so Dynatech's WACC is the appropriate discount rate. Some argue incorrectly that because Dynatech will disappear in the merger, the cash flows will become Amalgamated's, so Amalgamated's WACC is the appropriate discount rate. However, the relevant criterion is the risk of the cash flows, not who owns them or what we call them.c. Estimate Dynatech's value at the end of 2010 assuming it is worth the book value of its assets at the end of 2015.Terminal value in 2015708.40Present value of terminal value at 11%420.40Estimated firm value$543.48d. Based on your answer to (c) above, what is the maximum acquisition price Amalgamated should pay to acquire Dynatech?Estimated firm value543.48Existing interest-bearing debt259.32Estimated value of equity$284.16e. Estimate Dynatech's value at the end of 2010 assuming in the years after 2015 the company's free cash flow grows 3 percent per year in perpetuity.Terminal value in 20151,763.82Present value of terminal value at 11%1,046.74Estimated firm value$1,169.83f. Based on your answer to (e) above, what is the maximum acquisition price Amalgamated should pay to acquire Dynatech?Estimated firm value1,169.83Existing interest-bearing debt259.32Estimated value of equity$910.50g. Estimate Dynatech's value at the end of 2010 assuming that at year-end 2015 the company's equity is worth 20 times earnings and its debt is worth book value.Terminal value of equity in 20151,496.79Terminal value of debt in 201522.00Terminal value of firm in 20151,518.79Present value of terminal value at 11%901.33Estimated firm value$1,024.41h. Based on your answer to (g) above, what is the maximum acquisition price Amalgamated should pay to acquire Dynatech?Estimated firm value1,024.41Existing interest-bearing debt259.32Estimated value of equity$765.09i. Assuming Dynatech has 80 million shares outstanding, what maximum acquisition price per share is consistent with each of the three estimated values of equity determined in (d), (f) and (h)?(d)(f)(h)Estimated value of equity284.16910.50765.09Number of shares outstanding80.0080.0080.00Estimated value per share$3.55$11.38$9.56j. Why is the value per share estimated in part (d) so much lower than the other two?The value estimated in part (d) assumes a terminal value for Dynatech in 2015 equal to the book value of assets. Book value of assets is often a serious under-estimate of a company's market value. In 2015, Dynatech's return on invested capital is a healthy 12.6% and is assumed to grow at 3 percent per annum in perpetuity. It is no surprise that book value severely under states the terminal value of such a firm.2) a. Breaking up a firm could eliminate diseconomies of scale, which make large firms less efficient than smaller ones at certain tasks. Break up prevents managers from using cash generated by profitable activities to cross-subsidize uneconomic activities elsewhere in the enterprise. Finally, break up forces top management in each company to concentrate on a single market, thereby possibly improving management effectiveness. Each of these possible benefits promises to increase free cash flow and therefore market value.b. In the absence of increased cash flows, break up might still create value by increasing the enterprises appeal to investors who want to participate in some of the firms businesses but not others. In other words, investors may prefer "pure plays" to conglomerates. Thus breaking up a diversified company enhances value by giving investors what they want. On a more practical level, some executives argue that their company gets better coverage from security analysts after a break up. Prior to its break up, only railroad analysts covered Burlington Northern, despite the companys large investments in natural gas, real estate, timber, and other businesses. Management felt that because railroad analysts were unfamiliar with, and uninterested in, these other businesses, they assigned them little value. After spinning off the non-railroad activities into separate companies, management argued that improved analyst coverage was responsible for increased market values.3) a. There are three possible ways in which leveraging a firm might deter raiders. First, preemptive levering creates tax shields that likely add value. This makes the company more expensive to raiders. Equivalently, increasing leverage removes interest tax shields as one source of profit to a raider. Second, preemptive levering removes one easy source of financing for the raider. The easiest way to finance an acquisition is with the target's own excess liquidity and borrowing capacity. Remove these and you make acquisition financing more difficult. Third, depending on the companys ownership composition, the share repurchase that accompanies the increased leverage may increase the proportion of company shares in friendly hands.b. There are at least two potential sources of increased value: interest tax shields on the new debt and possible incentive effects. A large debt burden is a form of management bond guaranteeing owners that management will work hard to increase free cash flow and that they will devote more free cash flow to investor payments.c. Present value of tax shield = 0.34 x 0.12 x 100/0.14 = $29.1 million.d. With a times-interest-earned ratio of 7, EBIT exceeds interest expense sevenfold. EBIT could therefore fall to one-seventh of its current level before coverage reached the critical value of 1. This is an 86% decline ((7-1)/7 = .86). With a times-interest-earned ratio of 2, the corresponding percentage is 50% ((2-1)/2 = .50). As an aggressive, well-capitalized competitor I would think seriously about a price war. I can better withstand lower profits and potential losses than my newly levered competitor.4) a. Number of shares outstanding = $225/$12.79 = 17.59 million.Market value of equity = $5.50 x 17.59 million = $96.76 million.b. Market value of company = market value of equity + market value of debt = 96.76 + .70 x 2,500 = $1.85 billion.c. If investors were certain that Massey-Ferguson were going to liquidate, the companys stock price would equal the markets estimate of the per share liquidation value of equity, which would likely be zero. However prior to a liquidation announcement, Massey-Ferguson's equity is best viewed as an out-of-the-money option on the firm's assets. If the company liquidates, creditors get everything, and the option expires worthless. If the company avoids liquidation, the option goes in the money in the sense that the value of the company must exceed the value of its debt, and equity could be worth quite a bit. Because the return distribution to shareholders is truncated at zero, the expected return to shareholders can be positive even though there may be only a small probability Massey-Ferguson can avoid liquidation. Hence, the direct answer to this question is no, $5.50 is not the market's estimate of the liquidation value per share of Massey-Ferguson's equity.5) a. The maximum justifiable premium = the fair market value of Russell under new management - the fair market value of Russell under existing management.A plausible estimate of Russells fair market value under existing management is its standalone value = current market value of firm = $8 x 10 million + 75 million = $155 million.Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of hosiery divisionFair market value = $155 million + $4 million x 5.216 + $10 million = $185.86. Fair market value of equity = $185.86 - 75 = $110.86. Fair market of equity per share = $110.86/10 = $11.09. This is a 38.6% premium over the existing $8 share price.b. Fair market value of firm assuming a 15 percent discount rate and a $3.5 million annuity = 155 + 3.5(5.019) +10 = $182.57 million.Value of equity = 182.57 - 75 = 107.57. Value per share = 107.57/10 = $10.76. This is a 34.5% premium over the existing price.6) a. Price per share of Grubb stock = (100/(.10-.04) - 1,000)/20 = $33.33.b. Fair market value of equity per share after change in ownership = (110/(.10-.05) - 1,000)/20 = $60.00.

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MBD001BF2DA.doc2) a. Breaking up a firm could eliminate diseconomies of scale, which make large firms less efficient than smaller ones at certain tasks. Break up prevents managers from using cash generated by profitable activities to cross-subsidize uneconomic activities elsewhere in the enterprise. Finally, break up forces top management in each company to concentrate on a single market, thereby possibly improving management effectiveness. Each of these possible benefits promises to increase free cash flow and therefore market value.

b. In the absence of increased cash flows, break up might still create value by increasing the enterprises appeal to investors who want to participate in some of the firms businesses but not others. In other words, investors may prefer "pure plays" to conglomerates. Thus breaking up a diversified company enhances value by giving investors what they want. On a more practical level, some executives argue that their company gets better coverage from security analysts after a break up. Prior to its break up, only railroad analysts covered Burlington Northern, despite the companys large investments in natural gas, real estate, timber, and other businesses. Management felt that because railroad analysts were unfamiliar with, and uninterested in, these other businesses, they assigned them little value. After spinning off the non-railroad activities into separate companies, management argued that improved analyst coverage was responsible for increased market values.

3) a. There are three possible ways in which leveraging a firm might deter raiders. First, preemptive levering creates tax shields that likely add value. This makes the company more expensive to raiders. Equivalently, increasing leverage removes interest tax shields as one source of profit to a raider. Second, preemptive levering removes one easy source of financing for the raider. The easiest way to finance an acquisition is with the target's own excess liquidity and borrowing capacity. Remove these and you make acquisition financing more difficult. Third, depending on the companys ownership composition, the share repurchase that accompanies the increased leverage may increase the proportion of company shares in friendly shares.

b. There are at least two potential sources of increased value: interest tax shields on the new debt and possible incentive effects. A large debt burden is a form of management bond guaranteeing owners that management will work hard to increase free cash flow and that they will devote more free cash flow to investor payments.

c. Present value of tax shield = 0.34 x 0.12 x 100/0.14 = $29.1 million.

d. With a times-interest-earned ratio of 7, EBIT exceeds interest expense sevenfold. EBIT could therefore fall to one-seventh of its current level before coverage reached the critical value of 1. This is an 86% decline ((7-1)/7 = .86). With a times-interest-earned ratio of 2, the corresponding percentage is 50% ((2-1)/2 = .50). As an aggressive, well-capitalized competitor I would think seriously about a price war. I can better withstand lower profits and potential losses than my newly levered competitor.

4) a. Number of shares outstanding = $225/$12.79 = 17.59 million.

Market value of equity = $5.50 x 17.59 million = $96.76 million.

b. Market value of company = market value of equity + market value of debt = 96.76 + .70 x 2,500 = $1.85 billion.

c. If investors were certain that Massey-Ferguson were going to liquidate, the companys stock price would equal the markets estimate of the per share liquidation value of equity, which would likely be zero. However prior to a liquidation announcement, Massey-Ferguson's equity is best viewed as an out-of-the-money option on the firm's assets. If the company liquidates, creditors get everything, and the option expires worthless. If the company avoids liquidation, the option goes in the money in the sense that the value of the company must exceed the value of its debt, and equity could be worth quite a bit. Because the return distribution to shareholders is truncated at zero, the expected return to shareholders can be positive even though there may be only a small probability Massey-Ferguson can avoid liquidation. Hence, the direct answer to this question is no, $5.50 is not the market's estimate of the liquidation value per share of Massey-Ferguson's equity.

5) a. The maximum justifiable premium = the fair market value of Russell under new management - the fair market value of Russell under existing management.

A plausible estimate of Russells fair market value under existing management is its standalone value = current market value of firm = $8 x 10 million + 75 million = $155 million.

Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of hosiery division

Fair market value = $155 million + $4 million x 5.216 + $10 million = $185.86. Fair market value of equity = $185.86 - 75 = $110.86. Fair market of equity per share = $110.86/10 = $11.09. This is a 38.6% premium over the existing $8 share price.

b. Fair market value of firm assuming a 15 percent discount rate and a $3.5 million annuity = 155 + 3.5(5.019) +10 = $182.57 million.

Value of equity = 182.57 - 75 = 107.57. Value per share = 107.57/10 = $10.76. This is a 34.5% premium over the existing price.

6) a. Price per share of Grubb stock = (100/(.10-.04) - 1,000)/20 = $33.33.

b. Fair market value of equity per share after change in ownership = (110/(.10-.05) - 1,000)/20 = $60.00.