Ms Beaumont was particularly interested in CD because acquiring it will provide both operating and financial synergies. The operating synergies include economies of scale, and the continuation of their high growth in sales due to the additional equity gained. Economies of scale will be realised through a 5% reduction in cost of goods sold (COGS) and a 10% decrease in other expenses, through elimination of duplications. The firm’s sales will remain steady during the year of ownership change but will increase by 6% per year from 1988.
The financial synergies
The financial synergies of acquiring CD will be an increase in Friendly’s debt capacity, and the acquirement of additional equity through CD’s high level of retained earnings. Friendly is currently approaching its borrowing capacity and CD’s strong equity holdings will deliver them more financial flexibility. After Ms Beaumont met with the principals of CD, she calculated that the firm could be acquired for 11 times its 1987 earnings, which equals $1,881,000. CD’s management is satisfied with this amount and are willing to take payments in the form of 198,000 shares of Friendly common stock valued at .
50 per share.
The benefits of Friendly paying
One of the benefits of Friendly paying in common stock is that no debt has to be raised or cash paid in this transaction. This suits Friendly as they are currently at their debt capacity, and have insufficient cash to fund the purchase of CD. This exchange of securities will be a tax-free transaction. The acquisition will be treated as a pooling of interests for accounting purposes, which means the consolidated balance sheet will simply be the sum of the two firms’ individual statements.
The disadvantage of Friendly paying
One disadvantage is that current shareholders equity share is diluted due to the issue of new shares. Due to the fact that Friendly’s stock is currently trading at a two year low, Friendly must now give up more shares than if the stock was trading at a higher price. This further increases the dilution of current shareholders percentage holdings. Especially noteworthy is the loss of Ms. Beaumont’s majority control of the company. Her share holdings will fall from 55% to 41%.
The weighted average cost of capital (WACC) is an average of the returns required by both debt and equity holders in the firm weighted by their respective contribution to the market value of the firm. Therefore the cost of debt and equity and their respective market weights are needed. The cost of equity is a function of the risk free rate and an appropriate risk premium determined by CD’s beta. CD’s true beta was unable to be determined due to it being a privately traded company. A possible method of calculating CD’s beta is to regress their accounting earnings against the returns of the market.
This is not possible in this situation due to a lack of data on historical accounting earnings. A bottom up beta can also be constructed. This involves using comparable firms to obtain an industry unlevered beta, which is then levered back up with CD’s target debt/equity ratio. Using the comparable firms of American Greetings and Gibson Greetings, an unlevered industry beta of 0. 7345 is obtained. CD’s target debt/ratio is 0. 32, this is based on the average of the forecasted D/E ratio over the next 3 years. Given all this, CD’s levered beta is calculated to be 0. 8817.
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