Computer Concepts and Computech Merger Analysis

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Answer: CCI's cash flow statements, assuming the acquisition is made, are shown above in the model description section. Note that these statements are identical to standard capital budgeting cash flow statements, except that both interest expense and required retentions are included in the merger analysis. In straight capital budgeting, all debt involved is new debt issued to finance the asset being acquired. Hence, all the debt costs the same, kd, and this cost is accounted for by discounting the cash flows at the firm's WACC. In a merger, however, the acquiring firm usually assumes the existing debt of the target, and new debt is also issued to help finance the takeover. Thus, the debt involved has different costs; hence, it cannot be accounted for as a single cost in the WACC. The solution is to include interest expense explicitly in the cash flow statement.

With regard to required retentions, all the cash flows from an individual project are available for use throughout the firm, but some of the cash flows generated by an acquisition must generally be retained within the new division to help finance its growth. Since such retentions are not available to the parent company for use elsewhere, they must be deducted in the cash flow statement.

With interest expense and retentions included in the cash flow statements, the cash flows are residuals which belong to the equity holders. CompuTech's management could pay the free cash flows out as dividends, reinvest them elsewhere in the firm, retire debt, or do anything else they see fit. The situation here is a bit like finding the value of a share of stock as the PV of the expected future dividends. If we found the value of a stock as the PV of the earnings, that would overstate the true value. Similarly, if we valued the merger as the PV of the cash flows without recognizing that some cash flows must be retained to generate future cash flows, we would overvalue the merger.

Question 4 Conceptually, what is the appropriate discount rate to apply to the cash flows developed in Question 3? What is the numerical value of the discount rate? How much confidence can one place in this estimate, i.e., is the estimated discount rate likely to be in error by a small amount, such as 1 percentage point, or a large amount, such as 4 or 5 percentage points? Would an error in the discount rate have much of an effect on the maximum offer price?

Answer: As discussed above, the cash flows are residuals, hence, they belong to the shareholders. Since interest expense has already been considered, the cash flows are equity flows, so they must be discounted using the cost of equity rather than the WACC. Also, the discount rate must reflect the riskiness of the flows, and these cash flows have CCI's business risk, not CompuTech’s business risk, plus its financial risk because interest has been deducted. Though, that the risk of the CCI Division is not the same as CCI’s risk if it operated independently, because the merger would lead to a change in CCI's leverage and its tax rate.

To estimate the CCI Division's beta, we can first unlever CCI's market beta of 1.6 using Hamada's equation:

bLUnlevered beta = bU = 1 + (1 – T)(D/S)

.

1.6 1.6 1.6

=

1 + (1 – 0.30)(0.10/0.90)

=

1 + (0.7)(0.11)

=

1.078

= 1.48.

Note that the pre-merger tax rate and debt to equity ratio are used to unlever the beta. The resulting beta, 1.48, is the inherent beta of CCI's assets—if CCI had zero debt, and hence were unlevered, its beta would be 1.48. Next, this unlevered beta must be "relevered" to reflect the fact that the assets will be operated by CompuTech and will be financed with a debt ratio of 25 percent and subject to a tax rate of 40 percent:

bL = bU[1 + (1 — T)(D/S] = 1.48[1+(0.6)(0.25/0.75)] = 1.48(1.2) = 1.78.

Thus, to obtain the required rate of return on equity, note that kRF = 6.5% and RPM = 5%. Thus, CCI Division's required rate of return on equity, which is the appropriate discount rate to apply to the merger cash flows, is 15.41%:

ks(CCI) = kRF + (RPm)bCCI = 6.5% + (5%) 1.78 = 15.41%.

Although the discount rate was calculated to two decimal places, our confidence in its accuracy is low. First, CCI's market beta of 1.60 is merely an estimate of the true beta. Second, historical betas are not particularly good estimates of future market risk. Third, Hamada's equation requires all of the assumptions of the CAPM and of the Modigliani and Miller model, including no financial distress or agency costs. Thus, it can provide only a rough estimate of the effect of the acquisition on CCI's market risk. Finally, it is difficult to estimate the market risk premium at any point in time.

For all the reasons stated above, we should view the estimate of the discount rate as only an approximation. Since we do not know the real discount rate, we cannot measure the error. In our opinion, it would probably be 1 to 2 percentage points on either side of the estimate. Therefore, we would definitely be concerned about the sensitivity of the outcome to the discount rate.

We used the model to test the sensitivity of the maximum price to the discount rate. Here are the results:

K Max Price -------- ----------13.41% $4.64 14.41 4.35 15.41 4.11 16.41 3.90 17.41 3.71

The cost of equity is probably within the indicated range, and within that range, the offer price is somewhat but not terribly sensitive to discount rate variations.

Question 5 What is the terminal value of CCI, that is, what is the 1999 value of the cash flows CCI is expected to generate beyond 1999? What is CCI’s value to CompuTech at the beginning of 1996? Suppose another firm was evaluating CCI as a potential acquisition candidate. Would they obtain the same value? Explain.

Answer: The 1999 cash flow available to shareholders is $1,751,114, and it is expected to grow at a constant 5.0 percent rate beyond 1999. With a constant growth rate, the Gordon model can be used to value the cash flows beyond 1999:

(1999 Cash flow)(1 + g)

Terminal