Acquira Co.

Belva's preliminary scan of candidates yielded one firm in each industry that she thought would interest Stacey. The first, DB Supplies, a $1 billion company, manufactures a variety of devices used by hospitals. Her researched showed that DB has a price/earnings ratio of 20 and a debt to market value of equity of 20% . The consensus among analysts following the firm is that the growth rate in future cash flows should be 15%.

The second firm, Consolidated Healthco, is also a $1 billion company. Its P/E ratio is 30, and Debt to Equity ratio is 100%. The consensus among analysts following the firm was that the growth rate in future cash flows should be 20%.

In order to prepare a more thorough analysis of the acquisition candidate, Belva collected information about the long-term pattern of returns of all three firms, as well as information about the market. The quarterly time series of total returns for the last few years for each firm plus the S&P 500 are shown in Table I.

Assignment:

This assignment is due on March 27 at 5:00 PM. There are no exceptions to the deadline, since answer sheets will be immediately available outside my office at 223, 52 Hillhouse. The analysis can be done as a group, however each student must write up and submit the results individually.

1) Calculate the historical quarterly mean, and standard deviation for each stock and the market. Convert these numbers to annualized values by multiplying the quarterly mean returns by four, and the quarterly standard deviations by the square root of four.

2) Calculate the correlations among each of the four series, based upon quarterly data.

3) Estimate the beta of each of the three companies with respect to the S&P 500, based upon quarterly data.

4) Assume that the current riskless rate is 5.5%, and that the equity risk premium is 8%. Calculate the expected return for each of the three companies, based upon the Capital Asset Pricing Model.

5) Compare the actual returns over the period to the expected returns based upon the CAPM. Assume the t-bill rate was unchanged over the period. The difference between the actual return and the CAPM expected return is called Jensen's alpha. Are the alphas for each firm positive or negative? Is this a violation of the CAPM? Why or why not?

6) Assume there are no taxes. Estimate the asset beta of each of the three firms
7) Assume that Lehigh merges with DB.

What would be the combined standard deviation of the new firm?

What would be the beta of the new firm?

What would be the new expected return of the new firm?

What is the expected Sharpe ratio of the new firm?

8) Assume Lehigh merges with Consolidated.

What would be the combined standard deviation of the new firm?

What would be the beta of the new firm?

What would be the new expected return of the new firm?

What is the expected Sharpe ratio of the new firm?

9) Assume that a single-stage discounted cash flow model under certainty fairly represents the relationship between current price, earnings, discount rates and growth for each firm. That is:

using analysts' forecasts of the growth rate in earnings, gi, compared the discount rates implied by the P/E ratios for DB and Consolidated to those implied by the CAPM. Does either firm plot above or below the security market line?

10) What inferences do you draw from your analysis. In particular,

Which merger increases the probability of the new firm achieving a return in excess of treasury bills?

Is either firm a clear bargain?

What recommendation will you make to Stacey regarding the effect of either acquisition upon Lehigh?

Assuming the dividend growth model is approximately correct, and the CAPM discount rate is the appropriate one, what price would you suggest that Stacey pay for DB? What price would you suggest Lehigh pay for pay for Consolidated?