Ch 26-07 Build a Model Solution									3/7/2001
Chapter 26. Solution to 26-07 Build a Model
Wansley Portal Inc., a large Internet service provider, is evaluating the possible acquisition of Alabama
Connections Company (ACC), a regional Internet service provider. Wansley's analysts project the following post
merger data for ACC (in thousands of dollars):
			2002	2003	2004	2005
Net sales			$500	$600	$700	$760
Selling and administrative expense			60	70	80	90
Interest			20	23	25	28
If the acquisition is made, it will occur on January 1, 2002. All cash flows shown in the income statements are
assumed to occur at the end of the year. ACC currently has a capital structure of 30 percent debt, but Wansley
would increase that to 40 percent if the acquisition were made. ACC, if independent, would pay taxes at 30 percent,
but its income would be taxed at 35 percent if it werre consolidated. ACC's current market-determined beta is 1.40.
The cost of goods sold is expected to be 65 percent of sales, but it could vary somewhat. Depreciation-generated
funds would be used to replace worn-out equipment, so they would not be available to Wansley's shareholders. The
risk-free rate is 7 percent, and the market risk premium is 6.5 percent.
Tax rate of ACC before the merger					30%
Tax rate after merger					35%
Cost of goods sold as a % of sales					65%
Debt ratio (percent financed with debt) before the merger					30%
Debt ratio (percent financed with debt) after the merger					40%
Beta of ACC					1.40
Risk-free rate					7%
Market risk premium					6.5%
Terminal growth rate of cash flow available to Wansley					6.0%
a. What is the appropriate discount rate for valuing the acquisition?
In this analysis, the net cash flows generated are equity returns. Hence, the appropriate discount rate for this
analysis would be the cost of equity that reflects the risk inherent to this cash flow stream.
Step 1: Find the unlevered beta of ACC.
bU=	1.095
Step 2: Find the levered beta, reflecting the new capital structure and tax rate.
b=	1.569
Step 3: Use the CAPM to find the cost of equity
k S	=	k RF	+	MRP	*	Beta
k S	=	7.0%	+	6.5%	*	1.569
k S	=	17.20%
b. What is the horizon, or continuing, value? What is the value of ACC to Wansley's shareholders?
Before we can proceed with this problem, we must generate pro forma income statements for ACC's operations after
the proposed merger.
			2002	2003	2004	2005
Sales			$500.0	$600.0	$700.0	$760.0
Cost of Goods Sold			325.0	390.0	455.0	494.0
Gross Profit			175.0	210.0	245.0	266.0
Selling/admin. costs			60.0	70.0	80.0	90.0
EBIT			115.0	140.0	165.0	176.0
Interest			20.0	23.0	25.0	28.0
EBT			95.0	117.0	140.0	148.0
Taxes			33.3	41.0	49.0	51.8
Net Income/Cash Flow			$61.8	$76.1	$91.0	$96.2
* In this scenario, we state that net income and net cash flow are equal. This assumption arises from the fact that
all cash flows due to depreciation are being used to replace worn out capital.
To calculate the continuing value, we must determine the net cash flow for 2005. This is derived as the 2004 net
cash flow expanded at the terminal growth rate of cash flows. From this point, we can derive terminal value from the
basic DCF framework.
NCF 2006	=	NCF 2005	*	(1 + g)
NCF 2006	=	$96.20	*	1.06
NCF 2006	=	$101.97
TV 2005	=	NCF 2006	/	(k S	-	g)
TV 2005	=	$101.97	/	0.172	-	0.06
TV 2005	=	$101.97	/	0.112
TV 2005	=	$910.34
Now, we must add in the 2005 continuing value of future cash flows to the 2005 net cash flow. The resulting table of
cash flows will be as follows:
Year	2002	2003	2004	2005
NCF	$61.8	$76.1	$91.0	$1,006.5
To find the value of ACC to Wansley's shareholders, we must find the net present value of this cash flow stream,
discounted at the cost of equity.
NPV ACC	=	$698.03