case analysis

Topics: Weighted average cost of capital, Investment, Cash flow Pages: 13 (2337 words) Published: October 15, 2014

HARVARD EXTENSION SCHOOL
Mergers and Acquisitions MGMT E-2720
Spring 2014
Midterm Case – Sterling Household Products Company

Contents
a.How much business risk is associated with Sterling’s proposed acquisition of the germicidal, sanitation, and antiseptic products unit of Montagne Medical? 3 What is the cost of equity capital appropriate for evaluating the free cash flow associated with this investment? 4

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow? 4 b.What are the amounts and timing of the acquisition investment’s free cash flow from 2013 through 2022? 4 What is the terminal value of the final 10 years of the acquisition, as of 2022? 5 What is the net present value (NPV) to Sterling of this base investment? 5 What are the amounts and timing of the follow-up expansion investment opportunity’s free cash flow from 2013 through 2022? 5 What is the terminal value of the final 10 years of the follow-up acquisition, as of 2022? 5 What is the net present value of this follow-up investment and the combined base and expansion investments?6 c. Is acquisition of Montagne Medical’s germicidal, sanitation, and antiseptic products unit value-additive to Sterling?6 d.What are the strategic issues associated with the proposed acquisition? 6 What uncertainties or trends do you see which could make the acquisition more or less attractive on both a financial and a strategic basis?13

a. How much business risk is associated with Sterling’s proposed acquisition of the germicidal, sanitation, and antiseptic products unit of Montagne Medical?

Business risk – Beta – associated with Sterling’s proposed acquisition is 0.99. The Business risk is obtained from industry average. Unleveraged Beta represents the non-diversifiable risk, the risk that affects all firms within the industry. The risk of a company increases with a higher Debt/Equity ratio. Therefore Beta is leveraged on the Debt/Equity ratio of the specified company/investment. Step 1: Use Exhibit 7 for Data of the industry

There is one company – Vortex - that has unusual risk portfolio. Vortex is active in a wide variety of medical products, what might be one reason for the low unlevered risk (beta = 0.45) but there must be more specific arguments. The other three companies which act in a wide variety of products show normal unlevered Betas. Therefore, I exclude Vortex from the calculation. Step 2: Calculate Average of unlevered Beta of the industry; use equation for constant capital structure

Step 3: Relever industry’s AVG of unlevered Beta on Montagne Medical/germicidal, sanitation, antiseptic products; use constant capital structure for future investment: E/V is given and it is 0.70.

What is the cost of equity capital appropriate for evaluating the free cash flow associated with this investment? Current Yield to maturity of Long-term US Treasury bonds are defined as risk free rate of 3.1%. The market premium is given with 5.0%. Ke = Risk free rate + beta * market risk premium

Ke longterm= 3.10%+0.99*5.0%=8.05%
The appropriate cost of equity is 8.05%.

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow? The capital structure for future investments is given as 30% long-term debt (D) and 70% equity (E). Tax rate is 35.0%. WACC= Ke * E/(D+E) + Cost of debt *(1-Taxrate) * D/(D+E)

WACC=8.05%*0.7+5.10%*0.65*0.3=6.63%
Weighted average cost of capital is 6.63%.

b. What are the amounts and timing of the acquisition investment’s free cash flow from 2013 through 2022? There are some adjustments to the US GAAP cash flow statement needed for valuation purposes. For valuation purposes, the free cash flow is: (see excel sheet/Target for more details) EBIT * (1 - taxrate)

+ depreciation/amortization
+/- changes in working capital
+/- cash flow from investments
= Free cash flow to the...
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