A sporting goods manufacturer has decided to expand into another related business. Management has estimated that to build and staff a facility of the desired size would cost $450 million in present value terms. As an alternative, the company could acquire an existing company with the desired capacity. The book value of the alternative company is $250 million, and its earnings before interest and taxes is presently $50 million. Publicly traded comparable companies are selling in a range of 12 times current earnings. The companies have book value debt-to-asset ratios averaging 40 percent with an average interest rate of 10%.
1. Using a tax rate of 34%, what is the minimum price the owner should consider for its sale?
2. What is the maximum price the acquirer should be willing to pay?
3. Does it appear that an acquisition is feasible?
4. Would a 25 percent increase in stock prices to an industry average price-to-earnings ratio of 15 change your answer to 3?
5. Referring to the $450 million price as the replacement value of the division, what would you predict would happen to acquisition activity when market values of companies and divisions rise above their replacement values?