A B C D E F

1 Tool Kit Chapter 22

2 Mergers and Corporate Control
3
4 In theory, merger analysis is quite simple. The acquiring firm performs an analysis to value the target company. The acquiring firm then
5 the firm at preferably below that estimated value. Meanwhile, the target company would only want to accept the offer is the price exceed
6 operated independently. In practice, however, the process of merger analysis is much more involved and raises some difficult issues.
7
8 While many valuation techniques exist, we shall focus upon the discounted cash flow method. Regardless of the method used, it is crucia
9 recognize that the target company typically will not continue to operate as a separate entity, but rather it becomes part of the acquiring fi
10 portfolio of risky assets. This is significant because the operational changes that may occur will affect the value of the business and must
11 considered. In addition, it is important to remember that the goal of merger evaluation is to value the target company's equity, because t
is acquired from the company's owners, not its creditors. For that reason, our focus will be the value of equity, not total value.
12
13
14 22-7 Estimating a Target’s Value
15
16
17 Inputs
18 Date of valuation: 1/1/2020
19 Value of debt (D) on: 12/31/2019 $38.0 million
20 Value of stock (S) on: 12/31/2019 $154.0 million
21 Number of shares of stock: 10.0 million
22 Tax rate (T): 25%
23 Risk-free rate (r RF
): 6.0%
24 Beta (b) 1.4
25 Market risk premium (RP M
): 5%
26 Cost of debt (rd): 8%
27 Long-term growth rate (gL): 5%
28 Target debt weight for WACC (wd): 20%
29 Target equity weight for WACC (wS): 80%
30
31
32 22-7a Projecting Post-Merger Cash Flows
33
34
35 Tutwiler's Pre-Merger Cost of Equity and WACC (Based on Target Capital Structure
36
37 rSL = rRF + Beta *
38 rSL = 6% + 1.4 *
39 rSL = 13.00%
40
41 wd = 20.0000%
42 ws = 80.0000%
43
44 WACC = wdrd(1-T) + wSrSL
45 WACC = 1.20% + 10.40%
46 WACC = 11.6000%
47
 A B C D E F
48 Following are projections from the worksheet labeled "Explanation of Projections".
49
50 Figure 22-2
51 Projected Postmerger Cash Flows for the Tutwiler Subsidiary as of December 31 (Millions of Dollars)
52 1/1/20 12/31/20 12/31/21 12/31/22
53 Panel A: Selected Items from Projected
54 Financial Statements
55 . Net sales $155.0000 $170.0000 $185.0000
56 . EBIT $24.0000 $28.0000 $32.0000
57 . Interest expensea $3.6380 $3.8696 $4.1697
58 . Debt b
$45.4750 $48.3701 $52.1210 $55.7071
59 . Total net op. capital $114.8000 $120.9000 $132.6000 $144.3000
60 Panel B: Compressed APV
61 Model Cash Flows
62 . NOPAT = EBIT(1-T)c $18.0000 $21.0000 $24.0000
63 . Less net investment in op. capital $6.1000 $11.7000 $11.7000
64 . Free cash flow $11.9000 $9.3000 $12.3000
65 . Interest tax savings = Interest(T) $0.9095 $0.9674 $1.0424
66 Notes:
67 a
Interest payments are based on Tutwiler’s existing debt, new debt to be issued to finance the acquisition,
and additional debt required to finance annual growth.
68
69 b
Debt is existing debt plus additional debt required to maintain a constant capital structure. Caldwell will
70 increase Tutwiler's debt by $7.475 million from $38 million to $45.475 million at the time of the
71 acquisition in order to keep the capital structure constant. This increase occurs because the post-merger
synergies make Tutwiler more valuable to Caldwell than it was on a stand-alone basis. Therefore, it can
72 support more dollars of debt and still maintain the constant debt ratio.
73
74 c
The tax rate is 25%.
75
76
77
78 22-7b Valuation Using the Compressed APV Approach
79
80
81 Valuation Using the APV Model
82
83 First, estimate Tutwiler's unlevered cost of equity
84
85 rsU = wS rsL + wd rd
86 rsU = 0.800 0.130 + 0.200 0.08
87 rsU
= 12.000%
88
89 Alternatively, estimate the unlevered beta and then use the CAPM to estimate the unlevered cost of equity.
90
91 Because the cost of debt is greater than the risk-free rate, we must find the implied beta on the debt before we can estimate the
92 unlevered beta. In other words, if we assume that the CAPM is correct for the equity, we must also assume it is correct for the debt,
93 else we would be comparing apples to oranges, not apples to apples.
94
95 We can start with the observed cost of debt and use the CAPM to estimate the implied beta on the debt.
96
 A B C D E F
97 bd = [rd − rRF]/RPM
98 bd = 0.40
99
100 bU = [b + bd (wd/ws)] / [1 + (wd/ws)]
101 bU = 1.2000
102
103 rsU = rRF + bU RPM
104 rsU = 12.00%
105
106 First, calculate Tutwiler's horizon value if it were unlevered:
107 HVU = [ FCF2024 𝗑 (1 + g) ] ÷ (rsU
108 HVU = 19.6050 𝗑 1.050 ÷ 0.12000
109 HVU = $294.0750
110
111 Second, calculate the horizon value of Tutwiler's tax shields:
112 HVTS = TS2024 𝗑 (1 + g) ÷ (rsU
113 HVTS = 1.18818 𝗑 1.050 ÷ 0.1200
114 HVTS = $17.8227
115
116 Cash flows for the value of unlevered operations
117 12/31/20 12/31/21 12/31/22
118 FCF 11.9000 9.3000 12.3000
119 Horizon value of FCF at rSU
120 Total CF (FCF and horizon value) 11.9000 9.3000 12.3000
121 Discount rate for FCF = rSU 12.00%
122
123 Unlevered V Ops = $213.5544
124
125 Cash flows for the value of tax shield
126 12/31/20 12/31/21 12/31/22
127 Interest tax savings = Interest(T) 0.9095 0.9674 1.0424
128 Horizon value of interest tax shield at rsU
129 Total CF (Tax savings and horizon valu 0.9095 0.9674 1.0424
130 Discount rate for FCF = rsU 12.00%
131
132 V TS = $13.82059
133
134 The value of Tutwiler's operations to Caldwell is the sum of the unlevered value of operations and the
135 value of the tax shield:
136
137 VOps = Unlevered VOps + VTS
138 = $213.5544 + $13.8206
139 VOps = $227.3750
140
141 Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is the sum of the
142 unlevered value of operations and the value of the tax shield:
 A B C D E F
143 The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.
144
145 VEquity = VOps − Debt
146 = $227.37 − $38.00
147 VEquity = $189.3750
148
149
150
151
152 22-8 Setting the Bid Price
153
154 Analysis of the Tutwiler Acquisition with No Change in Capital Structure (Millions of Dollars)
155
156 Tutwiler as a Separate Tutwiler as a Subsidiary
157 Company Prior to the with No Change
158 Acquisition in Capital Structure
159 Value of equity: $154.00 $189.37
160 Value of debt: $38.00 $38.00
161 Total value: $192.00 $227.37
162
163 Number of Tutwiler shares 10
164 Current Tutwiler price per share $15.40
165
166 Maximum amount Caldwell should pay for Tutwiler's equity: a $189.4
167 Maximum price Caldwell should pay for Tutwiler's stock per share: b $18.94
168
169 Minimum bid is Tutwiler's pre-merger stock price: $15.40
170 Maximum bid is Tutwiler's post-merger value to Caldwell: $18.94
171
172 Notes: a
Calculated as the total value as a subsidiary minus the amount of debt as a separate company.
173 b
Calculated as the maximum amount divided by the 10 million shares of Tutwiler stock.
174
175
176 Cash Offers
177
178 Tutwiler's stockholders would not accept less than their current price of $15.40 and Caldwell should not offer more than Tutwiler's
179 post-merger value of $18.94. The bid price should be somewhere in between. For example, Caldwell might offer $16.40 cash for
180 each share of Tutwiler stock.
181
182 Stock Offers
183
184 Tutwiler's stockholders would probably prefer a cash offer. To induce them to exchange their shares of stock for shares of stock in
185 the new post-merger company, to be called Caldwell-Tutwiler, they would probably require a higher price. For example, Caldwell
186 might have to offer $16.80 in new stock for each share of Tutwiler stock.
187
188
189 Analysis of a Stock Offer (Millions except per share data)
190
191 Price offered to Tutwiler's stockholders: $16.80
192 Number of outstanding Tutwiler shares: 10
 A B C D E F
193 Total value of post-merger CaldwellTutwiler that must be received by Tutwiler's stockhold $168.00
194
195
196 Pre-merger stock price of Caldwell: $40.53
197 x Pre-merger number of outstanding shares of Caldwell: 20
198 Pre-merger value of Caldwell's equity: $810.60
199
200 + Post-merger value of Tutwiler's equity to Caldwell: $189.4
201 Post-merger value of CaldwellTutwiler's equity: $1,000.0
202
203 Percent of equity that must be owned by Tutwiler's former shareholders
204 Post-merger value owned by Tutwiler's former shareholders: $168.0
205 ¸ Post-merger value of CaldwellTutwiler's equity: $1,000.0
206 % of equity due to Tutwiler's former shareholders 16.80%
207
208 Number of new shares that must be owned by Tutwiler's former shareholders
209
210 % shares due to Tutwiler's former shareholders = %Tut = % of equity due to Tutwiler's former shareholders
211 %Tutwiler = nNew / (nNew + nOld)
212
213 Solving for nNew :
214
215 nNew = (%Tutwiler x nOld ) / (1 - %Tutwiler )
216 = 4.04
217
218 Tota l shares after the merger:
219
220 Total new shares 4.04
221 + Total shares before the merger 20.00
222 Total shares after the merger 24.04
223
224 Post-merger value of Caldwell's equity $1,000
225 ¸ Total shares after the merger 24.04
226 New value per share of Caldwell stock $41.60
227
228
229 Verify post merger value owned by Tutwiler's former shareholders:
230
231 Post-merger value to Tutwiler's shareholder = nNew (New value per share)
232 = 4.04 x $41.60
233 = $168.00
234
235 How many post-merger shares will Tutwiler's shareholders receive for each of their shares?
236
237 Exchange ratio = #shares received by target shareholders in post-merger firm = 0.404
238 # shares given up by target shareholder in target firm
239
240
241
242
243
 A B C D E F
244 22-14 Financial Reporting for Mergers
245
246 Firm A will acquire Firm B. Current laws only allow for purchase accounting.
247
248 Table 22-1 Accounting for Mergers: A Acquires B
249
250 Purchase Accounting Postmerger: Firm A
251 Firm A Firm B $20 Paid a
$30 Paida
252 (1) (2) (3) (4)
253 Current assets $50 $25 $75 $75
254 Fixed assets 50 25 65 75
255 Goodwilld 0 0 0 0
256 Total assets $100 $50 $140 $150
257
258 Debt $40 $20 $60 $60
259 Common equity 60 30 80 80
260 Total claims $100 $50 $140 $140
261 Notes:
262 a
The price paid is the net asset value, that is, total assets minus debt.
263 b
In column (3) we assume that Firm B's current and fixed assets are writen down from $25 to $15 before constru
264 consolidated balance sheet.
265 c
In column (4) we assume that Firm B's current and fixed assets are both increased to $30.
266 d
Goodwill refers to the excess paid for a firm above the apprised value of the physical assets purchased. Goodw
267 represents payment both for intangibles such as patents and for "organization" value such as that associated w
268 an effective sales force.
269 e
In column (3), Firm B's common equity is reduced by $10 prior to consolidation to feflect the fixed asset write-o
270 f
In column (5), Firm B's equity is increased to $50 to reflect the above-book purchase price.
271
272 Table 22-2 Income Statement Effects of Purchase Accounting
273
274 Firm A Firm B Purchase
275 (1) (2) (3)
276 Sales $100.0 $50.0 $150.00
277 Operating costs 72.0 36.0 $109.00 a
278 Operating income $28.0 $14.0 $41.00
279 Interest (10%) 4.0 2.0 $6.00
280 Taxable income $24.0 $12.0 $35.00
281 Taxes (25%) 6.0 3.0 $8.75
282 Earnings after taxes $18.0 $9.0 $26.25
283 Goodwill write-off 0.0 0.0 $0.00 b
284 Net income $18.0 $9.0 $26.25
285 EPSc $3.00 $3.00 $2.92
286 Notes:
287 a
Operating costs are $1 higher than they otherwise would be to reflect the higher reported costs (depreciation a
288 goods sold) caused by the physical asset markup at the time of purchase.
289 b
Prior to 2001 goodwill was written off over its expected life. Now goodwill is subject to an annual "impairment
290 fair market value has decreased during the year then goodwill is reduced, otherwise it is not.
291 c
Firm A had six shares and Firm B had three shares before the merger. A gives one new share for each of B's, so
292 shares outstanding after the merger.
 G H I
1 11/23/2018
2
3
he acquiring firm performs an analysis to value the target4 company. The acquiring firm then seeks to buy
value. Meanwhile, the target company would only want5to accept the offer is the price exceeds its value if
er, the process of merger analysis is much more involved 6 and raises some difficult issues.
7
8
hall focus upon the discounted cash flow method. Regardless of the method used, it is crucial to
9 it becomes part of the acquiring firm's
will not continue to operate as a separate entity, but rather
10 the value of the business and must be
ecause the operational changes that may occur will affect
member that the goal of merger evaluation is to value the
11 target company's equity, because the business
its creditors. For that reason, our focus will be the value of equity, not total value.
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37 RPM
38 5%
39
40
41
42
43
44
45
46
47
 G H I
48
49
50
51
52 12/31/23 12/31/24
53
54
55 $200.0000 $210.00000
56 $34.0000 $36.54000
57 $4.4566 $4.75273
58 $59.4091 $62.37955
59 $156.0000 $163.80000
60
61
62 $25.5000 $27.40500
63 $11.7000 $7.80000
64 $13.8000 $19.60500
65 $1.1141 $1.18818
66
s are based on Tutwiler’s existing debt, new debt to be 67
issued to finance the acquisition,
bt required to finance annual growth.
68
69
ebt plus additional debt required to maintain a constant capital structure. Caldwell will
70 at the time of the
s debt by $7.475 million from $38 million to $45.475 million
er to keep the capital structure constant. This increase71occurs because the post-merger
utwiler more valuable to Caldwell than it was on a stand-alone basis. Therefore, it can
ars of debt and still maintain the constant debt ratio. 72
73
%. 74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
nd then use the CAPM to estimate the unlevered cost of89 equity.
90
isk-free rate, we must find the implied beta on the debt91before we can estimate the
92
e that the CAPM is correct for the equity, we must also assume it is correct for the debt,
es, not apples to apples. 93
94
95
96
 G H I
97
98
99
100
101
102
103
104
105
106
107 − g)
108 − 0.05
109
110
111
112 − g)
113 − 0.05
114
115
116
117 12/31/23 12/31/24
118 13.8000 19.6050
119 294.0750
120 13.8000 313.6800
121
122
123
124
125
126 12/31/23 12/31/24
127 1.1141 1.18818
128 17.82273
129 1.1141 19.01091
130
131
132
133
134
135
136
137
138
139
140
141
142
 G H I
t Caldwell will purchase, is the value of operations less143
the debt.
144
145
146
147
148
149
150
151
152
153
Change in Capital Structure (Millions of Dollars) 154
155
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170
171
total value as a subsidiary minus the amount of debt as172
a separate company.
maximum amount divided by the 10 million shares of 173 Tutwiler stock.
174
175
176
177
178
ss than their current price of $15.40 and Caldwell should not offer more than Tutwiler's
hould be somewhere in between. For example, Caldwell 179
might offer $16.40 cash for
180
181
182
183
184
fer a cash offer. To induce them to exchange their shares of stock for shares of stock in
Caldwell-Tutwiler, they would probably require a higher185price. For example, Caldwell
ach share of Tutwiler stock. 186
187
188
r share data) 189
190
191
192
 G H I
193
194
195
196
197
198
199
200
201
202
203
204
205
206
207
208
209
210
= % of equity due to Tutwiler's former shareholders
211
212
213
214
215
216
217
218
219
220
221
222
223
224
225
226
227
228
229
230
231
232
233
234
235
236
237
238
239
240
241
242
243
 G H I
244
245
y allow for purchase accounting. 246
247
248
249
250
Postmerger: Firm A
251 $50 Paida Is price paid equal to NAV?
252 (5)
253 $80 c
254 80 c
255 10
256 $170
257
258 $60
259 110 f
260 $170
261
262
assume that Firm B's current and fixed assets are writen263
down from $25 to $15 before constructing the
nce sheet. 264
assume that Firm B's current and fixed assets are both265
increased to $30.
266
the excess paid for a firm above the apprised value of the physical assets purchased. Goodwill
267 value such as that associated with having
nt both for intangibles such as patents and for "organization"
orce. 268
269 to feflect the fixed asset write-off.
m B's common equity is reduced by $10 prior to consolidation
270purchase price.
m B's equity is increased to $50 to reflect the above-book
271
272
273
274
275
276
277
278
279
280
281
282
283
284
285
286
e $1 higher than they otherwise would be to reflect the287
higher reported costs (depreciation and cost of
d by the physical asset markup at the time of purchase.288
289is subject to an annual "impairment" test. If its
dwill was written off over its expected life. Now goodwill
has decreased during the year then goodwill is reduced, 290
otherwise it is not.
291
res and Firm B had three shares before the merger. A gives one new share for each of B's, so A has nine
g after the merger. 292
 Explanation of Projections

INPUTS
Note: Do not make any changes here! All inputs here are linked to the worksheet named
"Chapter"
Date of valuation: 1/1/2020
Value of debt (D) on: 12/31/19 $38.0000 million
Value of stock (S) on: 12/31/19 $154.0000 million
Number of shares of Tutwiler stock: 10 million
Tax rate: 25%
Risk-free rate, rRF: 6.00%
Beta 1.4
Market risk premium, RPM: 5.00%
Cost of debt, rd: 8.00%
Long-term growth rate, gL: 5.00%
Target debt weight for WACC, w d: 20.00%
Target equity weight for WACC, w S: 80.00%

Financial statements for the preceding year

Note: Input values here. The worksheet "Chapter" has links to these values.

Income Statement 12/31/19

Net sales $140.000
Costs of goods sold excluding depreciation $98.000
Selling & admin. expense $8.400
Depreciation $11.200
EBIT $22.400
Interest expense $2.900
Profit before tax $19.500
Taxes $8.800
Net income $10.700
Balance Sheet: Assets
Operating current assets $11.200
Operating long-term assets $112.000
Total assets $123.200

Balance Sheet: Liabilities & Equity

Operating current liabilities $8.400
Debt $38.000
Total liabilities $46.400
Common stock (par plus paid-in capital) $44.800
Retained earnings $32.000
Total common equity $76.800
Total liabilities & equity $123.200

Inputs to be used in projecting operating items Pre-Horizon

Actual Projected Projected Projected
12/31/19 12/31/20 12/31/21 12/31/22
Net sales $140.00 $155.00 $170.00 $185.00
Costs of goods sold (excluding depreciation)/Sales 70.0000% 69.5000% 69.5000% 69.5000%
Selling & admin. Expense/Sales 6.0000% 5.5000% 5.5000% 5.5000%
Depreciation/Operating long-term assets 10.0000% 10.0000% 10.0000% 10.0000%
Operating current assets/Sales 8.0000% 8.0000% 8.0000% 8.0000%
Operating long term assets/Sales 80.0000% 76.0000% 76.0000% 76.0000%
Operating current liabilities/Sales 6.0000% 6.0000% 6.0000% 6.0000%
Step 1: Use the Target Capital Structure to Calculate the WACC
g nopat 7.143% 16.67% 14.29%
These are calculated in the worksheet "Chapter" using these formulas: g total cap 5.314% 9.68% 8.82%
g in fcf 0.000% -21.85% 32.26%
rSL = rRF + b (RPM )
WACC = wdrd(1-T) + wSrSL
Cost of equity, rs, based on target constant
target capital structure as calculated in worksheet "Chapter" = 13.00000%
WACC based on constant target capital structure
as caculated in worksheet "Chapter" = 11.60000%

Step 2. Project Operating Items and Calculate Free Cash Flow

Tutwiler directly forecasts sales levels each year in the forecast period rather than base them on growth
rates. Only sales beyond the horizon are based on the long-term growth rate. Although not required for
the analysis, we also project 1 year beyond the horizon to ensure that the future growth in FCF is in fact
the long-term growth rate shown in the inputs.

Note: the values shown below in red are numbers, not formul
rounded for the sake of exposition.
Actual Projected Projected Projected
Projected operating cash flows 12/31/19 12/31/20 12/31/21 12/31/22
Net sales $140.00000 $155.00000 $170.00000 $185.00000
Costs of goods sold excluding depreciation $98.00000 $110.20000 $119.58000 $128.60000
Selling & admin. expense $8.40000 $9.00000 $9.50000 $10.30000
Depreciation $11.20000 $11.80000 $12.92000 $14.10000
EBIT $22.40000 $24.00000 $28.00000 $32.00000
Operating current assets $11.20000 $12.40000 $13.60000 $14.80000
Operating long term assets $112.00000 $117.80000 $129.20000 $140.60000
Total operating assets $123.20000 $130.20000 $142.80000 $155.40000
Operating current liabilities $8.40000 $9.30000 $10.20000 $11.10000
Total net operating capital $114.80000 $120.90000 $132.60000 $144.30000
Change in total net operating capital $7.0000 $12.6000 $12.6000

FCF calculations Actual Projected Projected Projected

12/31/19 12/31/20 12/31/21 12/31/22
NOPAT $16.8000 $18.00000 $21.00000 $24.00000
Investment in net operating capital $6.10000 $11.70000 $11.70000
Free cash flow $11.90000 $9.30000 $12.30000

Check growth rates and return on invested capital

g in sales 10.714% 9.677% 8.824%
g in NOPAT 7.143% 16.667% 14.286%
g in total net operating capital 5.314% 9.677% 8.824%
g in investment in total net operating capital 91.803% 0.000%
g in FCF -21.849% 32.258%
Return on invested capital (ROIC) = NOPAT/Total operating assets 14.888% 15.837% 16.632%

Summary of FCF and growth in FCF

Projected Projected Projected
12/31/20 12/31/21 12/31/22
FCF $11.9000 $9.3000 $12.3000
Growth rate of FCF -21.85% 32.26%

Step 3: Calculate the Horizon Value of Operations and the Intrinsic Value of Operations
gL = 5.0000%
WACC = 11.6000% 1/1/20 12/31/20 12/31/21 12/31/22
 FCF 11.9000 9.3000 12.3000
Horizon value = FCF2023 (1+g)/(WACC - g)
Total FCF & HV 11.9000 9.3000 12.3000
Intrinsic value of operations = PV of total FCF & HV at WACC = 227.3750

Step 4: Calculate the Value of Operations Each Year

Because the capital structure is expected to be constant, which means that the WACC will be constant, we can discount free cash flow
WACCC. At the horizon, the value of operations is equal to the horizon value. In each year prior to the horizon, the value of operation
year's value of operations and FCF discounted back one year at the WACC. So the value of operations one year before the horizon is
FCFHorizon))/(1 + WACC). The value of operations at Year t is equal to (HV t+1 + FC t+1) /(1 + WACC). This allows us to estimate the value o
each year, rather than only in the first year.

gL = 5.000%
WACC = 11.600% 1/1/20 12/31/20 12/31/21 12/31/22
FCF 11.9000 9.3000 12.3000
Horizon value of FCF at WACC (from Step 3)
V op,t = (FCFt+1 + Vop,t+1)/ (1 + WACC) = 227.3750 241.8505 260.6052 278.5354

Step 5. Calculate the Projected Amount of Debt and Interest Each Year

1/1/20 12/31/20 12/31/21 12/31/22

Value of operations from corp valuation model = 227.3750 241.8505 260.6052 278.5354
Target capital structure, wd = 20.000%
Projected debt = wd (Projected Vop) = $45.4750 $48.3701 $52.1210 $55.7071

We assume debt is added at the end of a year (for example, December 31, Year t) This means that the debt at the beginning of the nex
example, January 1, Yeart+1 is equal to the debt at the end of the previous year (for example, December 31, Year t-1. Because the debt f
added only on the last day of the year, the interest expense each year is calculated as the level of debt at the beginning of the year (w
same as the debt at the end of the previous year) mulitplied by the interest rate. The debt shown for the current date will not be exa
the actual debt shown at the end of the previous year unless the actual debt ratio is equal to the target and the intrinsic value is equa
market value. Therefore, we adjust the debt on January 1 to be equal to the debt required to be consistent with the target capital stru
intrinsic value. In other words, the company must either borrow or repay some debt on January 1 to be consistent with the assumpti

rd = 8.00000% 1/1/20 12/31/20 12/31/21 12/31/22

Debt for calculating interest expensea $45.4750 $48.3701 $52.1210 $55.7071
Interest expense: Intt = rd Debtt-1 $3.6380 $3.8696 $4.1697
g in interest expense

a Note: The debt shown for the current date is not exactly equal to the actual date shown at the end of the previous year because the d
estimating the first year's interest expense must be modified on the first day of the year so that the capital strucutre remains constan

Complete the Income Statement, the Total Assets, and the Liabilities

Before completing the statements, it is necessary to determine the financial surplus or deficit, which determines the dividends and line of credit.

Determine financial deficit or surplus

A financial surplus or deficit occurs when the total of the forecasted liabilities & total stockholders' equity does not equal the total
liabilities. If there is a surplus, we assume that dividend payments eliminate the surplus. If there is a deficit, we assume that the
company will draw on a line of credit.
First calculate net income, which will be used later in this process.

1/1/20 12/31/20 12/31/21 12/31/22

 EBIT $24.0000 $28.0000 $32.0000
Interest $3.6380 $3.8696 $4.1697
Pre-tax earnings $20.3620 $24.1304 $27.8303
Tax $5.0905 $6.0326 $6.9576
Net income $15.2715 $18.0978 $20.8727

Use the previously calculated net income, operating liabilities, debt, common stock, and total assets to determine the financing surplus or deficit.

1/1/20 12/31/20 12/31/21 12/31/22

Change in operating liabilities $0.9000 $0.9000 $0.9000
Change debta $7.4750 $2.8951 $3.7509 $3.5860
Change in common stock (par plus paid-in-capital) $0.0000 $0.0000 $0.0000

Net income $15.2715 $18.0978 $20.8727

-Change in total assets $7.0000 $12.6000 $12.6000
Financing surplus (+) or deficit (-) $7.4750 $12.0666 $10.1487 $12.7588

Special dividend $7.4750 $12.0666 $10.1487 $12.7588

If deficit, then draw on LOC $0.0000 $0.0000 $0.0000 $0.0000

Income Statement
1/1/20 12/31/20 12/31/21 12/31/22
Net sales $155.0000 $170.0000 $185.0000
Costs of goods sold excluding depreciation $110.2000 $119.5800 $128.6000
Selling & admin. expense $9.0000 $9.5000 $10.3000
Depreciation $11.8000 $12.9200 $14.1000
EBIT $24.0000 $28.0000 $32.0000
Interest expense $3.6380 $3.8696 $4.1697
Profit before tax $20.3620 $24.1304 $27.8303
Taxes $5.0905 $6.0326 $6.9576
Net income $15.2715 $18.0978 $20.8727

Dividends $12.0666 $10.1487 $12.7588

Change in debt between 12/31 and 1/1 for first column $7.4750

Balance Sheet
Assets 1/1/20 12/31/20 12/31/21 12/31/22
Operating current assets $11.2000 $12.4000 $13.6000 $14.8000
Operating long-term assets $112.0000 $117.8000 $129.2000 $140.6000
Total assets $123.2000 $130.2000 $142.8000 $155.4000
$7.0000 $12.6000 $12.6000
Liabilities & Shareholders Equity 1/1/20 12/31/20 12/31/21 12/31/22
Operating current liabilities $8.4000 $9.3000 $10.2000 $11.1000
Debta $45.4750 $48.3701 $52.1210 $55.7071
Total liabilities $53.8750 $57.6701 $62.3210 $66.8071
7.044% 8.065% 7.198%
Common stock (par plus paid-in-capital) $44.8000 $44.8000 $44.8000 $44.8000
Retained earnings $24.5250 $27.7299 $35.6790 $43.7929
Total common equity $69.3250 $72.5299 $80.4790 $88.5929

Total liabilities & equity $123.2000 $130.2000 $142.8000 $155.4000

Check for balance: TA - TL & Equity $0.0000 $0.0000 $0.0000 $0.0000

a Note: The debt shown for the current date is not exactly equal to the actual date shown at the end of the previous year because the d
estimating the first year's interest expense must be modified on the first day of the year so that the capital structure remains constan
 11/23/2018

izon Horizon Post Horizon

Projected Projected Projected
12/31/23 12/31/24 12/31/25
$200.0000 $210.00 $220.50
69.5000% 69.5000% 69.5000%
5.5000% 5.5000% 5.5000%
10.0000% 10.0000% 10.0000%
8.0000% 8.0000% 8.0000%
76.0000% 76.0000% 76.0000%
6.0000% 6.0000% 6.0000%
 6.25% 7.47% 5.00%
8.11% 5.00% 5.00%
12.20% 42.07% 5.00%

n red are numbers, not formulas. They are

r the sake of exposition.
Projected Horizon Post Horizon
12/31/23 12/31/24 12/31/25
$200.00000 $210.00000 $220.5000
$139.80000 $145.95000 $153.2475
$11.00000 $11.55000 $12.1275
$15.20000 $15.96000 $16.7580
$34.00000 $36.54000 $38.3670
$16.00000 $16.80000 $17.6400
$152.00000 $159.60000 $167.5800
$168.00000 $176.40000 $185.2200
$12.00000 $12.60000 $13.2300
$156.00000 $163.80000 $171.9900
$12.6000 $8.4000

Projected Horizon Post Horizon

12/31/23 12/31/24 12/31/25
$25.50000 $27.40500 $28.7753
$11.70000 $7.80000 $8.1900
$13.80000 $19.60500 $20.5853

8.108% 5.000% 5.000%

6.250% 7.471% 5.000%
8.108% 5.000% 5.000%
0.000% -33.333% 5.000%
12.195% 42.065% 5.000%
16.346% 16.731% 16.731%

Projected Horizon Post Horizon

12/31/23 12/31/24 12/31/25
$13.8000 $19.6050 $20.5853
12.20% 42.07% 5.00%

12/31/23 12/31/24
 13.8000 19.6050
311.8977
13.8000 331.5027

we can discount free cash flows at the

horizon, the value of operations is the next
one year before the horizon is (HV +
allows us to estimate the value of operations

12/31/23 12/31/24
13.8000 19.6050
311.8977
297.0455 311.8977

12/31/23 12/31/24
297.0455 311.8977

$59.4091 $62.3795

debt at the beginning of the next year (for

r 31, Year t-1. Because the debt for a year is
at the beginning of the year (which is the
the current date will not be exactly equal to
t and the intrinsic value is equal t othe
stent with the target capital structure and the
be consistent with the assumptions.

12/31/23 12/31/24 12/31/25

$59.4091 $62.3795
$4.4566 $4.7527 $4.9904
6.646% 5.000%

he previous year because the debt level for

pital strucutre remains constant.

nds and line of credit.

12/31/23 12/31/24
 $34.0000 $36.5400
$4.4566 $4.7527
$29.5434 $31.7873
$7.3859 $7.9468
$22.1576 $23.8405

cing surplus or deficit.

12/31/23 12/31/24
$0.9000 $0.6000
$3.7020 $2.9705
$0.0000 $0.0000

$22.1576 $23.8405
$12.6000 $8.4000
$14.1596 $19.0109

$14.1596 $19.0109
$0.0000 $0.0000

12/31/23 12/31/24
$200.0000 $210.0000
$139.8000 $145.9500
$11.0000 $11.5500
$15.2000 $15.9600
$34.0000 $36.5400
$4.4566 $4.7527
$29.5434 $31.7873
$7.3859 $7.9468
$22.1576 $23.8405

$14.1596 $19.0109

12/31/23 12/31/24
$16.0000 $16.8000
$152.0000 $159.6000
$168.0000 $176.4000
$12.6000 $8.4000
12/31/23 12/31/24
$12.0000 $12.6000
$59.4091 $62.3795
$71.4091 $74.9795
6.889% 5.000%
$44.8000 $44.8000
$51.7909 $56.6205
$96.5909 $101.4205

$168.0000 $176.4000
$0.0000 $0.0000

he previous year because the debt level for

pital structure remains constant.