Reference no: EM131750901

Question: The Acquisitor Corporation, which is a tax-exempt financial institution (say a pension fund) is evaluating the purchase of the Bergan Co. The latter's only asset consists of an office building, the Bergan Tower, which is financed solely through common equity. Using discounted cash-flow analysis, the maximum price that could be paid for the target company's shares is found to be $20 million. If the merger with Bergon proceeds, Acquisitor expects to take advantage of Bergon's unused debt capacity. Specifically, it would arrange a $14 million, 30-year loan and make use of the proceeds to offset the purchase price. Current interest rates on such debt are 16 percent. This move toward an optimal capital structure is reflected in the $20 million maximum price computed for the acquisition. Another corporation, Argon, owning as its single asset an identical office tower, has emerged as an alternative acquisition target. The Argon merger would differ in that the target company carries a 1 0-percent, 30-year loan of $14 million on the building that can be assumed in the takeover. Neither loan involves a sinking fund.

(a) What maximum price would you recommend that the Acquisitor Corporation be willing to pay for Argon?

(b) If the price you are willing to pay for Argon differs from the $20 million you are willing to offer for Bergan, explain the reasons for the difference. Assume your audience to be Acquisitor's board of directors, a group not necessarily well versed in the technicalities of finance.

(c) We argued that historical costs on previously issued securities are irrelevant for investment evaluations. How do you reconcile that position with your answers derived above?

(d) If the Acquisitor Corporation were not a tax-exempt financial institution, how would your answer to (a) differ? Assume a tax rate of 40 percent.