Reference no: EM133377594
Question 1: The founder of Reostat Electric Inc is negotiating to sell the firm to its current management for $15 M in cash. The purchase price will be financed by $10M in notes that are repaid in $2 M increments over the next 5 years. At the end of the 5 year period the firm will have no remaining debt. The free cash flows of the firm are expected to be $3M per year over the next 5 years, and then beginning in year 6 they are expected to grow at 3% a year indefinitely. The unlevered cost of equity (Ku) is approximately 15%, the firm's borrowing rate on the debt is 10%, taxes are 30%, the long-term treasury bond is 7.5%. If you must make any additional assumptions, state them clearly.
a. Use the equity cash flow method to value of the firm.
b. Suppose that after prolonged negotiations, the owner of Reostat makes a concession to the firm's management, offering them seller financing at a below market interest rate of 9% instead of 10%. How much is this concession worth? (Hint: this is more complicated than substituting 10% for 9% in your spreadsheet)
c. Suppose instead that there are other potential bidders for the firm, and the founder has more negotiating power than the managers. The founder is still willing to provide the financing, but he will charge them the market interest rate of 10%. Moreover, since he does not want to bear any risk of default, he insists on some additional assurance that the loan and the interest will be repaid. In fact, he insists that the managers purchase a loan guarantee that will make the debt essentially risk-free. If the managers do so, how much will the loan be worth to the founder (i.e. how much value do the managers give up if they have to pay a fair price for the guarantee)?
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