United Technologies (UT), a jet engine manufacturer, agreed to acquire aircraft parts company, Rockwell Collins (Rockwell), for $30 billion, including $7 billion in assumed Rockwell debt, on September 4, 2017. According to the terms of the deal, Rockwell shareholders are to receive $140 per share. The purchase price consists of $93.33 in cash plus $46.67 in UT stock. The purchase price represents an 18% premium to Rockwells closing share price the day before the announcement. UTs aerospace business will be combined with Rockwell Collins to create a new business to be called Collins Aerospace Systems. UT anticipates about $500 million annually in cost savings by the fourth year following closing. Rockwell had completed its acquisition of B/E Aerospace on April 13, 2017. Free cash flow to the firm (FCFF) is projected to be $750 million in 2017 compared to $700 million prior to the acquisition. Free cash flow to the firm is expected to grow at 7% annually through 2022 and 2% thereafter. The firms beta is 1.22 and average borrowing cost is 4.8%. The equity risk premium is 5 percentage points. The 10 year Treasury bond rate is 2.2%. The debt to equity ratio is 1.39. The firms cost of capital in the years beyond 2022 is expected to be one-half of one percentage point below its level during the 2018 to 2022 period. The firms marginal tax rate is 40% and there is no cap on the tax deductibility of net interest expense. An analyst was asked if UT overpaid for Rockwell. She reasoned that to answer this question, she would have to estimate the standalone value of Rockwell and the present value of synergy. The upper limit on the purchase price should be the sum of the standalone value plus the present value of synergy. If the actual purchase price exceeded the upper limit, the firm would have overpaid for the Rockwell. In effect, UT would have transferred all the value created by combining the two firms (i.e., anticipated synergy) to Rockwell shareholders.

Discussion Questions

1. Estimate the firms cost of equity and after tax cost of debt.

2. Estimate the firms weighted average cost of capital. (Hint: Recall that the debt-to-total capital ratio is equal to the debt-to-equity ratio divided by one plus the debt-to-equity ratio.)

3. What is the WAAC beyond 2022?

4. Use the discounted cash flow method to determine the standalone value for Rockwell Collins. Show your work.