Fm Ii Smitty's

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Financial Management II
Smitty’s Home Repair Company
Merger Analysis

Submitted to:
Miss Ayesha Aijaz Toor

Submitted By:
Saadain Malik
Shahzaib Khan
Ahmad Raza
Talha Iqbal

Smitty’s home repair company, a regional hardware chain that specializes in “do-it-yourself” materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Linda wade, smitty’s treasurer and your boss, has been asked to place a value on a potential target, hill’s hardware, a small chain that operates in an adjacent state, and she has enlisted your help.

The table below indicates wade’s estimates of hill’s earnings potential if it came under smitty’s management (in millions of dollars).

2001 2002 2003 2004
NET SALES $60.0 $90.0 $112.5 $127.5
COST OF GOODS SOLD (60%) 36.0 54.0 67.5 76.5
SELLING/ADMINISTRATIVE EXPENSE 4.5 6.0 7.5 9.0
INTEREST EXPENSE 3.0 4.5 4.5 6.0
NECESSARY RETAINED EARNINGS 0.0 7.5 6.0 4.5

The interest expense listed here includes the interest:
* On hill’s existing debt,
* On new debt that smitty’s would issue to help finance the acquisition, and * On new debt expected to be issued over time
To help finance expansion within the new “h division,” the code name given to the target firm. The retentions represent earnings that will be reinvested within the h division to help finance its growth.

Hill’s hardware currently uses 40 percent debt financing, and it pays federal-plus-state taxes at a 30 percent rate. Security analysts estimate hill’s beta to be 1.2. If the acquisition were to take place, smitty’s would increase hill’s debt ratio to 50 percent, which would increase its beta to 1.3. Further, because smitty’s is highly profitable, taxes on the consolidated firm would be 40 percent. Wade realizes that hill’s hardware also generates depreciation cash flows, but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.

Wade estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. She also estimates that net cash flows after 2004 will grow at a constant rate of 6 percent. Smitty’s management is new to the merger game, so wade has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, wade has developed the following questions, which you must answer and then defend to smitty’s board.

A. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

Answer: The economically justifiable rationales for mergers are synergy and tax consequences. Synergy occurs when the value of the combined firm exceeds the sum of the values of the firms taken separately. (If synergy exists, then the whole is greater than the sum of the parts, and hence synergy is also called the “2 + 2 = 5” effect.)

A synergistic merger creates value that must be apportioned between the stockholders of the merging companies. Synergy can arise from four sources: (1) operating economies of scale in management, production, marketing, or distribution; (2) financial economies, which could include higher debt capacity, lower transactions costs, or better coverage by securities’ analysts that can lead to higher demand and, hence, higher prices; (3) differential management efficiency, which implies that new...
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