Question

Penn Corp. is analyzing the possible acquisition of Teller Company. Both firms have no debt. Penn believes the acquisition will increase its total aftertax annual cash flow by $2 million indefinitely. The current market value of Teller is $54 million, and that of Penn is $84 million. The appropriate discount rate for the incremental cash flows is 10 percent. Penn is trying to decide whether it should offer 45 percent of its stock or $72 million in cash to Teller’s shareholders.

a. What is the cost of each alternative? (Do not round intermediate calculations. Enter your answers in dollars, not millions of dollars, i.e. 1,234,567.)
Cash cost $
Equity cost $
b. What is the NPV of each alternative? (Do not round intermediate calculations. Enter your answers in dollars, not millions of dollars, i.e. 1,234,567.)
NPV cash $
NPV stock $
c. Which alternative should Penn choose?
Stock
Cash

Answer 1

Penn Corp.

a. Cost of each alternative:

Cash cost $72 million

Equity cost $37.8 million

b) The NPV of each alternative:

NPV cash -$52 million ($20 - $72)

NPV stock $20 million ($20 - $0)

c. The alternative to choose:

Stock.

There is no cash flow with the offer of 45% of Penn's stock to the shareholders of Teller. Actually, there is no NPV with stock offer, except the administrative costs of issuing the shares to Teller's shareholders.

Step-by-step explanation:

a) Data and Calculations:

After-tax annual cash flow = $2 million

Discount rate for the incremental cash flows = 10%

Present value of the perpetuity = $20 million ($2 m/10%)

Current market value of Teller = $54 million

Current market value of Penn = $84 million

Possible settlement options:

45% of stock = $37.8 million ($84 million * 45%)

Cash $72 million