Eastern Steel Manufacturing is
- Eastern Steel Manufacturing is considering acquiring ChicagoIron Works. Eastern Steel
expects Chicago Iron Works’ free cashflow in the first year following the closing date forthe
acquisition will be $125 million andthat it will grow thereafter at the rate of 10% per year for
the next 5 years. Eastern Steel’s WACCfor the acquisition is 12%, and its investment banker
estimates that the perpetuity growthrate for calculating the terminal value is 2% per year.
- Specify Chicago Iron Works’ free cash flow stream for years 1through 6.
- Estimate the terminal value for the acquisition.
- Calculate the value of Chicago Iron Works.
- Eastern Steel believes it can acquire Chicago Iron Works for$1.6 billion. Should Eastern Steel proceed with theacquisition? Justify your answer.
Answer:
(All values in million)
a) Free cash Flow to Firm(FCFF1)=$125
FCFF2=FCFF1(1+g1) [where,g1=growth rate for 1st phase=10%]
Year | FCFF($) |
1 | FCFF1=125(1+0.10)=137.5 |
2 | FCFF2=137.5(1+0.10)=151.25 |
3 | FCFF3=151.25(1+0.10)=166.38 |
4 | FCFF4=166.38(1+0.10)=183.01 |
5 | FCFF5=183.01(1+0.10)=201.31 |
6 | FCFF6=201.31(1+0.10)=221.45 |
b) Terminal Value(V6):
V6= FCFF7/(K0-g2)[where g2=perpetuity growth rate=2%=FCFF6(1+g2)/(0.12-0.02) K0=Costof Capital=WACC=12%] =221.45(1+0.02)/0.10 =$ 2258.79
c) Value of Chicago Iron works(V):
[Where, n=number of years] =
=$1597.69 million
d) Eastern Steel believes it can aquire ChicagoIron works at $1.6 billion.
Here we found the value of the firm as $1597.69million or 1.59billion which is almost near to 1.6 billion. Therefore EasternSteel should proceed with its acquisition.
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