Explain why should the private equity firm acquire xyz firm

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Reference no: EM13335608

Assume the firm, called XYZ, is acquired for $220 (the price for the assets = new invested capital) by a private equity firm. The private equity firm issues substantial debt to buy the firm, which leads to a high cost of equity and debt; although, it hopes to improve the firm and earn a high ROE and return on capital to compensate for this added risk.

Values of firm XYZ before acquisition
$100 Sales
$18 EBIT (18% of sales)
$4 Interest (4% interest rate on debt)
$14 EBT
40% Tax rate
$8.4 Net income
$200 Assets = invested capital
$100 Debt
$100 Equity
8.40% ROE (net income / equity)
5.40% ROIC (NOPAT / invested capital)
8.00% Cost of equity
2.40% After-tax cost of debt
5.20% WACC (using book values)
0.20% EVA (i.e., ROIC - WACC)
To compute the new WACC:

The old equity is gone since the firm is purchased. To fund the purchase, the private equity firm assumes all existing $100 debt at the current 4% interest rate, borrows $100 in new debt with a 12% interest rate, and contributes $20 in equity. The cost of this contributed equity is 20%. The new firm has a 40% tax rate.

Additional information to compute the new ROE and ROIC:

Following the acquisition, EBIT rises from 20% of sales from 18% of sales and sales rise to $105 as the private equity firm improves operations, and the tax rate is unchanged.

1. What is the new ROE?
a) 8.70%
b) 12.00%
c) 14.00%
d) 15.00%
e) 44.70%

2. What is the new WACC?
a) 4.00%
b) 6.18%
c) 8.36%
d) 9.09%
e) 9.42%

3. If the private equity firm uses EVA (i.e., ROIC - WACC) as a criteria for determining whether to make acquisitions, should the private equity firm acquire XYZ firm?
a) Yes
b) No
c) Cannot be determined based on information provided

Reference no: EM13335608

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