1. Dave’s Pizza – Fulton Pizza Merger

Dave’s pizza is considering a mergerwith Fulton Pizza. The offer under discussion is a cash offer of$352 million for Fulton Pizza. Both companies have niche markets inthe pizza industry, and the companies believe a merger will resultin significant synergies due to economies of scale in manufacturingand marketing, as well as significant savings in general andadministrative expenses.

Matt Robinson, the financial officerfor Dave’s, has been instrumental in the merger negotiations. Matthas prepared the following pro forma financial statements forFulton assuming the merger takes place. The financial statementsinclude all synergistic benefits from the merger:

	2015	2016	2017	2018	2019
Sales	$512,000,000	$576,000,000	$640,000,000	$720,000,000	$800,000,000
Production costs	359,200,000	403,200,000	448,000,000	505,600,000	564,000,000
Depreciation	   48,000,000	    51,200,000	    52,800,000	    53,120,000	    53,600,000
Other expenses	   51,200,000	    57,600,000	    64,000,000	    72,320,000	    77,600,000
EBIT	$ 53,600,000	$ 64,000,000	$ 75,200,000	$ 88,960,000	$104,800,000
Interest	   12,160,000	    14,080,000	    15,360,000	    16,000,000	    17,280,000
Taxable Income	$ 41,440,000	$ 49,920,000	$ 59,840,000	$ 72,960,000	$ 87,520,000
Taxes @40%	   16,576,000	    19,968,000	    23,936,000	    29,184,000	    35,008,000
Net Income	$ 24,864,000	$ 29,952,000	$ 35,904,000	$ 43,776,000	$ 52,512,000

Matt knows that Fulton will requireinvestments each year for maintenance of plant. The table below hasrequired investments and sources of financing:

	2015	2016	2017	2018	2019
Investments
Net working capital	$ 12,800,000	$ 16,000,000	$16,000,000	$19,200,000	$19,200,000
Fixed assets	     9,600,000	    16,000,000	    11,520,000	    76,800,000	     4,480,000
Total	   22,400,000	$ 32,000,000	$ 27,520,000	$ 96,000,000	$ 23,680,000  Â
Sources of financing
New debt	$ 22,400,000	$ 10,240,000	$ 10,240,000	$    9,600,000	$    7,680,000
Profit retention	                  0	    21,760,000	    17,280,000	    17,280,000	    16,000,000
Total	   22,400,000	    32,000,000	    27,520,000	    26,880,000	    23,680,000

The management of Dave’s feels thatthat capital structure at Fulton is not optimal. If the mergertakes place, Fulton will immediately increase its leverage with a$71 million debt issue, which would be followed by a $96 milliondividend payment to Dave’s. This will increase Fulton’sdebt-to-equity ratio from 0.50 to 1.00. Dave’s will also be able touse a $16 million tax loss carryforward in 2016 and 2017 fromFulton’s previous operations. The total value of Fulton is expectedto be $576 million in five years, and the company will have $192million in debt at that time.

Stock in Dave’s currently sells for$94 per share, and the company has 11.6 million shares of stockoutstanding. Fulton has 5.2 million shares of stock outstanding.Both companies can borrow at 8%. The risk-free rate is 6%, and theexpected return on the market is 13%. Matt believes the currentcost of capital for Dave’s is 11%. The beta for Fulton at itscurrent capital structure is 1.30.

Matt has asked you to analyze thefinancial aspects of the potential merger. Specifically, he hasasked you to answer the following questions:

1. Suppose Fulton’s shareholders will agree to a merger price of$68.75 per share. Should    Dave’s proceed with themerger?
2. What is the highest price per share that Dave’s should bewilling to pay for Fulton?
3. Suppose Dave’s is unwilling to pay cash for the merger but willconsider a stock exchange. What exchange ratio would make themerger terms equivalent to the original merger price of $68.75 pershare?
4. What is the highest exchange ratio Dave’s would be willing topay and still undertake themerger?