1. (45 points) Calculate the value of Carborundum (on an aggregate and per share basis) using both the Free Cash Flow to Capital (FCFcap) and Free Cash Flow to Equity (FCFeq) methods.
Use the following assumptions:
Note: Rf=5.6%; MRP=8.8%, Carborundum’s levered beta (prior to deal)=1.16
FCFeq=Net Income + Non Cash Deductions-Capital Expenditures-Change in Net Working Capital-Debt
Repayment+ Debt Issuances + Miscellaneous Extras

Answer:
Value of Kennecott using FCFcap is: $53.8
Value of Kennecott using FCFeq is: $49.91

Steps using FCFcap:
Step 1:
FCF_cap=EBIT(1-t)+depreciation+ amortization -Capex-change of NWC
=NI+Interest(1-t) - Change of Net PPE - Change of NWC

Step 2:
WACC calculation:
WACC=%Equity * Re + %Debt*Rd*(1-t)
Re=Rf+beta*MRP=15.8%
So, WACC= 65%*15.8%+35%*10%*(1-0.5)=12.03%
Step 3:
Multiply FCF with corresponding discount factors (1/(1+WACC)^n)

PV(FCFcap)= 166.12
Step 4:
Terminal value of equity = 116.2*10 – 117.1=1044.9
Terminal Enterprise value = equity value + debt value – cash = 1044.9 + 391 – 0 = 1435.9
Step 5:
Total Enterprise value = PV(10year FCFcap) + PV(TV) = 166.12 + 461.28= 627.4
Equity Value = Total Enterprise value – Debt = 653.73 - 186.2= 441.2
Step 6:
Per share value = equity value/share numbers= 441.2/8.2=53.8

Steps using FCFeq:
Step 1:
FCFeq=NI + Non Cash Deductions-Capital Expenditures-Change in NWC-Debt Repayment+ Debt
Issuances

Step 2:
Re=Rf+beta*MRP=15.8%
Step 3:
Multiply FCFeq with corresponding discount factors (1/(1+Re)^n)

PV(FCFeq)= 168.45
Step 4:
Terminal value of equity = 116.2*10-117.1=1044.9

PV(TVeq)=240.82
Step 5:
Total Equity value = PV(FCFeq)+PV(TVeq)= 168.45 + 240.82= 409.27
Step 6:
Per share value = equity value/share numbers= 409.27/8.2=49.91

2. (45 points) Where exactly is Kennecott adding value to Carborundum? Estimate the value additions (synergies) on a per share basis and add them to Carborundum’s pre-deal price of
$33 per share. Does the result agree with the DCF valuation in Question #1? Why or why not?
Step 1:
Synergy related with Tax:

PV(all tax synergy)=49.59
Step 2:
Synergy reflected in extra dividends:
Note: the profit retention requirement for Carborundum to maintain sales growth has been reduced significantly after acquisition, which is also a form of embedded implied synergy, i.e.,
Carborundum can more effectively using retained earnings to achievement same growth rate.
The pre-deal dividend payout ratio is about 25%, the post-deal dividends payout ratio stabilized at about 57%, which are shown below:

Step 3:
Aggregated FCF impact:

Step 4:

Present value:
Since these tax benefits and extra dividends impact entire FCFcap instead of only FCFeq, I choose to use WACC for the calculation.
PV(tax+others)= 149.58
Note: DTS from 100m new debt of Carborundum is 100*(1-50%) = 50, but this should not be added onto synergy, because the tax shield benefits has already been taken into consideration in the dividends to Kennecott.
Step 5:
a) If we don't take the dividend embedded synergy into consideration, the per share tax-related synergy is 49.59/8.2=6.05. Adding to current price $33, we get $39.05, which is far below the value calculated in FCFcap and FCFeq.
It’s because: First, the dividend-embedded synergy is not considered here. Second, the price from FCF method may have overestimated the sales growth which is not reflected in the current
$33 stock price. Third, the FCF may overestimate the multiple of 10x P/E ratio at Year 10. Fourth, the FCF method may have used a relatively lower discount rate which boosts the valuation.
Lastly, the FCF method reflect intrinsic value, but the current price $33 is market fair value, which may be lower due to the market expectation and macro stock market condition (economic downturn, etc..)
b) If we add the dividend embedded synergy, the toal synergy is 149.58; on per share basis is
$18.24. Add on to current stock price $33, we get $51.24, which is in between $53.8 (FCFcap) and 49.9 (FCFeq). The results basically match because some of the discrepancy factors mentioned above are captured in extra dividends.

3. (10 pints) Would you recommend Kennecott buy Carborundum for $66 per share? What do you predict will happen to Kennecott and its stock price if it proceeds with the deal on the proposed terms?
I wouldn't recommend Kennecott buy Carborundum for $66 per share, it’s overvalued. Even after taking the control premium into consideration, I would still only recommend a lower acquisition price.
Since Kennecott overpaid Carborundum, the post-deal stock price of Kennecott will decline a bit to reflect the purchase of an expensive target firm. Except stock price, Kennecott’s earnings may become less volatile due to diversification. Also, regarding the over-estimated goodwill, in 1977, the old accounting rule still allows Goodwill to be amortized over a certain time period; however, if goodwill could be impaired (impairment test), in the next couple of years the earnings may

decline due to the impairment of goodwill, which could cause EPS to be reduced. Lastly, since the deal is over paid, which means the P/E ratio of Carborundum is overestimated, so the deal will be relatively more dilutive than a reasonable-price deal’s EPS impacts.
Moreover, the strategic synergy for this deal is very small. The major synergies are financial-wise, like tax credit usage and tax benefits from asset write-up. So, in the long run, the consolidated earnings may drop since Kennecott may not have expertise/management team to run
Carborundum well.