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Case+Study+1+ +Hughes+Solution
Case+Study+1+ +Hughes+Solution
Mini-Case:
GMs bid for Hughes Aircraft Corporation
Set-up of the Case: In 1985 GM is considering the acquisition of Hughes Aircraft Corporation. Hughes Aircraft Corporation, currently owned by the Howard Hughes Medical Institute, is essentially a defense contractor. If GM is successful this will represent the largest industrial merger ever. GM is competing with Ford and Boeing which are also biding for Hughes Aircraft.
Hughes Aircraft is a private company: there are no traded shares of Hughes. Therefore GM has no information on Hughes equity beta. The relevant available information from Hughes Aircraft is: Expected after-tax earnings of $300 million this year. Expected (nominal) growth rate of cash flows of 4% per year. Hughes has no debt but, GM has set a Target D/E of 1.0, after the acquisition.
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Other relevant information: marginal corporate tax rate: 34% market return: 14% Some information on GM: equity beta (E) is 1.2 with a current debt to equity ratio (D/E) of 0.4. discount rate for debt (equal to riskless rate): 8% However the business risk of GM is unlikely to be an appropriate measure for the business risk of Hughes.
Since Hughes Aircraft is not a traded company GM has no direct information on its risk/beta. GMs consultants were able to collect information on two of Hughes competitors, which are public companies: Lockheed and Northrop. Lockheed has a E of 0.90 while Northrop has a E of 0.85 With regards to their capital structures, Lockheed has a D/E of 0.90 while Northrop has a D/E of 0.70 The cost of debt for each these two firms is 9.5%
Questions:
1) Compute your best measure of the NPV(WACC) for this acquisition. 2) Repeat the previous calculation using the WACC of GM.
So we need to know the return on equity for Hughes, and its capital structure. Since the target debt to equity ratio is 1, then we know that D/V = E/V = 0.5 As for the return on equity we need to use the CAPM:
We dont have the equity beta of Hughes but we can use the information on Lockheed and Northrop Using the equity betas for these two companies we have:
rE , N 0.08 0.85 * (0.14 0.08) 13.1% rE , L 0.08 0.9 * (0.14 0.08) 13.4%
However, the capital structures are different across the three firms: we cant compare their equity risk, we must compare their business risk!
rA = rDD/V + rEE/V. For Northrop we have D/E = 0.7 so: rA,N=9.5%*0.412+13.1*0.588=11.617% For Lockheed we have D/E = 0.9 so: rA,N=9.5%*0.474+13.4*0.526=11.55%
So we can take 11.585% as our best estimate of the business risk of Hughes.
Corporate Finance MBA 2008 GMs Bid for Hughes Aircraft (Mini-Case)
DH E rE ,H H VH VH
WACC=(1-0.34)*9.5%*0.5+13.67*0.5=9.97%
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GM has a debt to equity ratio of 0.4 so DGM/VGM = 0.286 and EGM/VGM = 0.714. We still need the return on equity. Using the CAPM:
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Substituting those in the WACC expression: WACCGM = 12.36% And the corresponding NPV of the acquisition would be: