FINANCE-Marston Marble Corporation is considering a merger with the Conroy Concrete

Marston Marble Corporation is considering a merger with the
Conroy Concrete

Company.
Conroy is a publicly traded company, and its beta is 1.30. Conroy has been

barely
profitable, so it has paid an average of only 20% in taxes during the last
several

years. In
addition, it uses little debt; its target ratio is just 25%, with the cost of
debt 9%.

If the
acquisition were made, Marston would operate Conroy as a separate, wholly

owned
subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate

would
therefore increase to 35%. Marston also would increase the debt
capitalization in

the Conroy
subsidiary to wd = 40%, for a total of $22.27 million in debt by the end of

Year 4, and
pay 9.5% on the debt. Marston’s acquisition department estimates that

Conroy, if
acquired, would generate the following free cash flows and interest expenses

(in millions
of dollars) in Years 1–5:

year
free cash flow
interest expense

1
1.3

1.2

2
1.5

1.7

3
1.7

2.8

4
2

2.1

5
2.12

?

In Year 5,
Conroy’s interest expense would be based on its beginning-of-year (that is,
the

end-of-Year-4)
debt, and in subsequent years both interest expense and free cash flows are

projected to
grow at a rate of 6%.

These cash
flows include all acquisition effects. Marston’s cost of equity is 10.5%, its

beta is 1.0,
and its cost of debt is 9.5%. The risk-free rate is 6%, and the market risk
premium

is 4.5%.

a. What is
the value of Conroy’s unlevered operations, and what is the value of Conroy’s

tax shields
under the proposed merger and financing arrangements?

b. What is
the dollar value of Conroy’s operations? If Conroy has $10 million in debt

outstanding,
how much would Marston be willing to pay for Conroy?

 

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