Reference no: EM131859930

GM considers acquiring Hughes Aircraft Corporation

In 1989, General Motors (GM) was evaluating the acquisition of Hughes Aircraft Corporation.

Recognizing that the appropriate WACC for discounting the projected cash flows for Hughes was different from General Motors' WACC, GM assumed that Hughes was of approximately the same risk as Lockheed or Northrop which had low-risk defense contracts and products that were similar to those of Hughes. Specifically, assume:

Firm βE D/E

GM 1.20(BE) 0.40(D/E)

Lockheed 0.90(BE) 0.90(D/E)

Northrop 0.85(BE) 0.70(D/E)

• GM's target D/E after acquisition of Hughes is 1

• Lockheed and Northrop maintain fixed levels of debt

• Hughes’s expected after-tax real asset cash flow next year = $300 million each year in perpetuity

• Corporate tax rate = 34%

• rm = 11.7% and rf = 4%

• Debt is riskless, so that the appropriate rD = rf, and βD = 0.

a) Analyze the Hughes acquisition (which never took place) by first computing the betas of the comparison firms, Lockheed and Northrop, as if they were all equity financed (i.e. by unlevering the betas).

b) Compute βA, the beta of the operating assets of the Hughes acquisition by taking the average of the betas of the operating assets of Lockheed and Northrop.

c) Compute the βE for the Hughes acquisition at the target debt level.

d) Compute the value of Hughes using the most appropriate method.

e) Now suppose that GM decides it does not have a target D/E ratio for the combined firm after the acquisition. Instead, GM plans to use $3 billion of fixed perpetual debt as external financing for the acquisition. What method is now most appropriate for valuing Hughes? What is the value of Hughes using this method?