To justify the acquisition price of Kenneth Cole Productions with the given WACC, the company would need an annual free cash flow of $26.08375 million. This necessitates an EBIT margin of approximately 8.36% given current annual sales of $480 million and a tax rate of 35%.
The student's question is about calculating the level of annual free cash flow that would justify the acquisition price of Kenneth Cole Productions, and the required EBIT margin given certain financial data. To find the annual free cash flow that justifies the acquisition price, we need to discount the free cash flows at the given weighted average cost of capital (WACC) of 11%. With $15.25 per share for 18.5 million shares, the total equity value is $282.125 million, and considering the $45 million in cash with no debt, the enterprise value is $237.125 million. To justify this value with a WACC of 11%, we are looking for an annual free cash flow (AFCF) where:
Enterprise Value = AFCF / WACC
Substituting in the given values:
$237.125 million = AFCF / 11%
AFCF = $237.125 million × 11% = $26.08375 million
For part b, with current annual sales of $480 million and given that there are no net capital expenditures or increases in net working capital, and with a tax rate of 35%, we must find the EBIT margin that would result in the $26.08375 million AFCF. After-tax profit is EBIT × (1 - tax rate). We need to ensure that the EBIT, after tax, equals the annual free cash flow required. Hence:
EBIT × (1 - 0.35) = $26.08375 million
EBIT = $26.08375 million / 0.65
EBIT = $40.12846 million
Thus, EBIT margin is EBIT divided by sales:
EBIT margin = $40.12846 million / $480 million
EBIT margin = approximately 8.36%
Therefore, to justify the acquisition price, KCP would need to achieve an annual free cash flow of $26.08375 million, which corresponds to an EBIT margin of roughly 8.36%.