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Hagers Home Repair Company, a regional hardware chain, which specializes in do-it-yourself materials and equipment rentals, is considering an acquisition of Lyon Light-ing (LL). Doug Zona, Hagers treasurer and your boss, has been asked to place a value on the target and he has enlisted your help. LL has 20 million shares of stock trading at $12 per share. Security analysts estimate LLs beta to be 1.25. The risk-free rate is 5.5% and the market risk premium is 4%. LLs capital structure is 20% financed with debt at an 8% interest rate; any additional debt due to the acquisition also will have an 8% rate. LL has a 25% federal-plus-state tax rate, which will not change due to the acquisition. The following data incorporate expected synergies and required levels of total net operating capital for LL should Hagers complete the acquisition. The forecasted inter-est expense includes the combined interest on LLs existing debt and on new debt. After 2024, all items are expected to grow at a constant 6% rate. 2019 2020 2021 Net sales Cost of goods sold Selling/administrative expense Total net operating capital Debta Note: a $64 $30 2022 2023 2024 $150 $170 $186 $200 $212 $116 $128 $135 $ 22 $ 26 $ 85 $ 75 $ 50 $ 52 $ 52 $148 $160 $ 27 $ 28 $ 32 $ 93 $100 $106 $ 53 $ 54 Debt is added on the first day of the year, so the 2019 debt is LLs debt prior to the acquisition. Hagers management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To struc-ture the task, Zona has developed the following questions, which you must answer and then defend to Hagers board:

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) synergy, (2) tax considerations, (3) breakup value, (4) risk reduction through diversification, (4) purchase of assets at below-replacement cost, and (5) managerial incentives. In general, which of the reasons are economically justifiable? Which are not?

b. Briefly describe the differences between a hostile merger and a friendly merger.

c. What are the steps in valuing a merger using the compressed APV approach?

d. Why cant we estimate LLs value to Hagers by discounting the FCFs at the WACC? What method is appropriate? Use the projections and other data to determine the LL divisions free cash flows and interest tax savings for 2020 through 2024. Notice that the LL divisions sales are expected to grow rapidly during the first years before leveling off at a sustainable long-term growth rate.

e. Conceptually, what is the appropriate discount rate to apply to the cash flows devel-oped in part d? What is your actual estimate of this discount rate?

g. Should Hagers make an offer for Lyon Lighting? If so, how much should it offer per share?

h. Considerable research has been undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research?

i. What method is used to account for mergers?

j. What merger-related activities are undertaken by investment bankers?

k. What are the major types of divestitures? What motivates firms to divest assets?

L. What are holding companies? What are their advantages and disadvantages?

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