Question

Wheatley Corp. is analyzing the possible acquisition of Romney Company. Both firms have no debt. Wheatley believes the acquisition will increase its total after-tax annual cash flows by $1.9 million, indefinitely. The current market value of Romney is $41 million, and that of Wheatley is $79 million. The appropriate discount rate for the incremental cash flows is 10%. Wheatley is trying to decide whether it should offer 40% of its stock or $57 million in cash to Romney's shareholders. Which option should Wheatley choose?

1) Offer 40% of its stock
2) Offer $57 million in cash
3) Cannot be determined
4) Not enough information provided

Answer 1

The better option for Wheatley Corp to acquire Romney Company is to offer 40% of its stock since the calculated present value of the future cash flows is $19 million, and 40% of Wheatley's stock is valued at $31.6 million, which is less than the $57 million cash offer.

Step-by-step explanation:

Choosing the Best Acquisition Offer

When Wheatley Corp. considers acquiring Romney Company, it estimates an increase in after-tax annual cash flows by $1.9 million indefinitely. To determine which offer is better, calculating the present value of the incremental cash flows at the appropriate discount rate is necessary. The present value (PV) of these cash flows using a discount rate of 10% is PV = $1.9 million / 0.1 = $19 million. This represents the added value to Wheatley Corp. from the acquisition.

Offering 40% of Wheatley's stock translates to 0.4 * $79 million = $31.6 million, which is lower than the present value of the incremental cash flows. Therefore, this offer is economically more favorable to Wheatley than offering $57 million in cash. Based on this financial analysis, the better option for Wheatley would be to offer 40% of its stock to acquire Romney Company.