| Marston Marble Corporation is considering a merger with the Conroy Concrete |
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| Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been |
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| barely profitable, so it has paid an average of only 20% in taxes during the last several |
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| years. In addition, it uses little debt; its target ratio is just 25%, with the cost of debt 9%. |
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| If the acquisition were made, Marston would operate Conroy as a separate, wholly |
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| owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate |
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| would therefore increase to 35%. Marston also would increase the debt capitalization in |
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| the Conroy subsidiary to wd = 40%, for a total of $22.27 million in debt by the end of |
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| Year 4, and pay 9.5% on the debt. Marston’s acquisition department estimates that |
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| Conroy, if acquired, would generate the following free cash flows and interest expenses |
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| (in millions of dollars) in Years 1–5: |
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| year | free cash flow | interest expense | |||||||||||
| 1 | 1.3 | 1.2 | |||||||||||
| 2 | 1.5 | 1.7 | |||||||||||
| 3 | 1.7 | 2.8 | |||||||||||
| 4 | 2 | 2.1 | |||||||||||
| 5 | 2.12 | ? | |||||||||||
| In Year 5, Conroy’s interest expense would be based on its beginning-of-year (that is, the |
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| end-of-Year-4) debt, and in subsequent years both interest expense and free cash flows are |
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| projected to grow at a rate of 6%. |
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| These cash flows include all acquisition effects. Marston’s cost of equity is 10.5%, its |
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| beta is 1.0, and its cost of debt is 9.5%. The risk-free rate is 6%, and the market risk premium |
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| is 4.5%. | |||||||||||||
| a. What is the value of Conroy’s unlevered operations, and what is the value of Conroy’s |
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| tax shields under the proposed merger and financing arrangements? |
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| b. What is the dollar value of Conroy’s operations? If Conroy has $10 million in debt |
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| outstanding, how much would Marston be willing to pay for Conroy? |
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