10. A buyer currently has a market cap (equity value) of $1 billion, with $100M in cash $100M of existing debt, and $200M in EBITDA and $100M in Net Income. Its cash interest rate is 1%, its interest rate on debt is 8%, and its tax rate is 40%. It’s considering acquiring a seller that is worth $500 million (Equity Value) and has a P / E of 20x. What financing structure should the buyer use?
a. 100% stock ($500 million of stock), since its cash is minimal and it cannot afford to raise more debt
b. 100% debt ($500 million of debt), since its cash is minimal and stock would make this too dilutive
c. 10% cash ($50 million of cash) and 90% debt ($450 million of debt) since it can easily afford to raise more debt, but should maximize cash usage first
d. 20% cash ($100 million of cash) and 80% debt ($400 million of debt) since it can easily afford to raise more debt, but should maximize cash usage first
ANSWER IS C.
i. Explanation: First, let’s calculate the “cost” of cash, debt, and stock for the buyer. Cost of Cash = 1% * (1 – 40%) = 0.6%, so clearly that’s the cheapest. Cost of Debt = 8%* (1 – 40%) = 4.8%. Cost of Stock = Reciprocal of P / E multiple = 1 / ($1 billion / $100M) = 10.0%. The seller’s “yield” is 1/20, or 5%. So it looks like anything with 100% cash and 100% debt will be Accretive here, and 100% stock will make it more and more dilutive. So A is clearly wrong – we want to use as little stock as possible, especially since the company can likely afford to use some cash and raise some debt. B is wrong because cash is still cheaper to use than debt, and we can likely afford to use some of that cash balance. That leaves us with C and D. D is wrong because you can never use 100% of the company’s cash in an M&A deal – it always needs some minimal amount on its Balance Sheet to continue operating and paying employees. So C is the best answer – use as much cash as possible since it’s cheapest, and then use as much debt as possible. At this level, the company’s leverage ratio, ignoring the seller’s EBITDA, would be 2.75x ($550 million of debt / $200 million in EBITDA), which is very reasonable and so high that it poses a serious risk to the combined company.
The above is what they give as the explanation, however I don't get it. I am confused on the Reciprocal part. can someone please explain this comprehensively? Thanks.
Company has Mkt. Cap of 1 billion with 100 million of net income. This means the required return for equity holders is 10%. The question is asking you to figure out the "cheapest" form of capital the company can use in an M&A transaction. As it lays out below:
1) Cash = 1% (tax effected = 0.6%) 2) Debt = 8% (tax effected = 4.8%) 3) Equity = 10%
C is the correct answer because you need some minimum cash after the transaction and debt is the next cheapest form of capital and you have the resources / EBITDA to raise it.
Make sense?
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