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Hagers Home Repair Company, a regional hardware chain, which specializes in do-ityourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hagers treasurer and your boss, has been asked to place a value on a potential target, Lyons Lighting, a small chain which operates in an adjacent state, and he has enlisted your help. The table below indicates Zonas estimates of Lyons earnings potential if it came under Hagers management (in millions of dollars). The interest expense listed here includes the interest (1) on Lyons existing debt, which is $55 million at a rate of 9%, and (2) on new debt expected to be issued over time to help finance expansion within the new L division, the code name given to the target firm. If acquired, Lyons' Lighting will face a 40% tax rate. Security analysts estimate that Lyons beta is 1.3. The acquisition would not change Lyons capital structure. out equipment. Zona realizes that Lyons Lighting also generates depreciation cash flows, all of which must be reinvested in the division to replace wornThe net retentions in the table below are required reinvestment in Zona estimates the risk-free rate to be 9 addition to these depreciation cash flows.

percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2008 will grow at a constant rate of 6 percent. Following are projections for sales and other items. 2005 Net sales Cost of goods sold (60%) Selling/administrative expense Interest expense Required net retentions $60.0 36.0 4.5 5.0 0.0 2006 $90.0 54.0 6.0 6.5 7.5 2007 $112.5 67.5 7.5 6.5 6.0 2008 $127.5 76.5 9.0 7.0 4.5

Hager management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hagers board.