Question

Alaska, Inc., would like to acquire Estoya Corp., which is located in Peru. In initial negotiations, Estoya has asked for a purchase price of 1 billion Peruvian new sol. If Alaska completes the purchase, it would keep Estoya's operations for 2 years and then sell the company. In the recent past, Estoya has generated annual cash flows of 500 million new sol per year, but Alaska believes that it can in crease these cash flows by 5 percent each year by improving the operations of the plant. Given these improvements, Alaska believes it will be able to resell Estoya in 2 years for 1.2 billion new sol. The current exchange rate of the new sol is $.29, and exchange rate forecasts for the next 2 years indicate values of $.29 and $.27, respectively. Given these facts, should Alaska, Inc., pay 1 billion new sol for Estoya Corp. if the required rate of return is 18 percent? What is the maximum price Alaska should be willing to pay?

Answer 1

Answer:

Yes, Alaska should pay 1 billion new sol for the acquisition.

Maximum price = 1.616 billion new sol.

Explanation:

Asking price by Estoya = 1 billion new sol.

However, estimating the value of Estoya considering the cash flows in years 1 and 2 to Alaska is as follows.

Year 1 cash flow (figures in millions)

• Cash flow (which will grown by 5% yearly) = 500 * 1.05 = 525
• In USD (exchange rate in year 1 = $.29), 525 = 525 * $.29 = $152.25.

Year 2 cash flow (figures in millions)

• Cash flow = 525 * 1.05 = 551.25
• Resale value = 1,200 (i.e 1.2 billion)
• Total year 2 cash flow = 1,751.25

• In USD (exchange rate in year 2 = $.27), 1,751.25 = 1,751.25 * $.27 = $472.84.

Given a discount rate of 18%, the present value of the cash flows

= $\frac{152.25}{1.18} +\frac{472.84}{(1.18)^{2} }$

= 129.03 + 339.59

= $468.62.

Therefore, the maximum amount Alaska Inc. should pay for the Company is the local currency equivalent of $468.62 in today's price

= 468.62/0.29

= 1.616 billion new sol.

Because this amount (the fair value) is higher that the 1 billion new sol the company intends to pay, Alaska should pay the 1 billion new sol.