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Chapter 5: Q1BP (page 649)

The Clark Corporation desires to expand. It is considering a cash purchase of Kent Enterprises for \(3 million. Kent has a \)700,000 tax loss carryforward that could be used immediately by the Clark Corporation, which is paying taxes at the rate of 30 percent. Kent will provide $420,000 per year in cash flow (aftertax income plus depreciation) for the next 20 years. If the Clark Corporation has a cost of capital of 13 percent, should the merger be undertaken?

Short Answer

Expert verified

Answer

Yes, the merger should be undertaken.

Step by step solution

01

Step-by-Step-SolutionStep 1: Calculation of net cash outflows and cash inflows

Net cash outflows and inflows are calculated as follows:

Cash outflow

Purchase price

$3,000,000

Less: Tax shield benefit from tax ($700,000 x 30%)

210,000

Net cash outflow

$2,790,000

Cash inflow

Present value of $420,000 x 7.025 (Appendix D)

(n = 20, i = 13%)

$2,950,500

Total present value of cash inflow

$2,950,200

02

Calculation of net present value

Net present value is calculated as follows:

Total present value of cash inflow

$2,950,200

Net cash outflow

2,790,000

Net present value

$160,500

Thus, the net present value equals $160,500. As it is positive, merger should be undertaken

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Most popular questions from this chapter

You are the vice president of finance for exploratory resources, headquartered in Houston, Texas. In January 20X1, your firm鈥檚 Canadian subsidiary obtained a six-month loan of 150,000 Canadian dollars from a bank in Houston to finance the acquisition of a titanium mine in Quebec province. The loan will also be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. \(0.8995/ Canadian dollars and the Canadian currency was selling at a discount in the forward market. The June 20X1 contract (face value = C\)150,000 per contract) was quoted at U.S. $0.8930/ Canadian dollar.

a. Explain how the Houston bank could lose on this transaction assuming no hedging.

b. If the bank does hedge with the forward contract, what is the maximum amount it can lose?

Why do management and stockholders often have divergent viewpoints about the desirability of a takeover?

What is synergy? What might cause this result? Is there a tendency for management to over- or underestimate the potential synergistic benefits of a merger?

If a firm wishes to achieve immediate appreciation in earnings per share as a result of a merger, how can this be best accomplished in terms of exchange variables? What is a possible drawback to this approach in terms of long-range considerations?

Assume the Knight Corporation is considering the acquisition of Day Inc. The expected earnings per share for the Knight Corporation will be \(4.00 with or without the merger. However, the standard deviation of the earnings will go from \)2.40 to $1.60 with the merger because the two firms are negatively correlated.

a.Compute the coefficient of variation for the Knight Corporation before and after the merger (consult Chapter 13 to review statistical concepts if necessary).

b.Discuss the possible impact on Knight鈥檚 postmerger P/E ratio, assuming investors are risk-averse.
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