NINA’s FASHIONS, INC Merger Analysis – Case 40 (Graded A+) - use as a guide only - 25415

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Merger Analysis – Case 40


Nina’s Fashions, Inc., operates a chain of retail clothing stores in Michigan, Wisconsin, and Illinois. The company has been in business since 1953, and until about 15 years ago, all of its stores were in older, downtown locations. However, in the late 1970s, the chain opened its first suburban store which differed significantly from the older stores. The new store was much larger, stocking many more items than the old stores. Many new stores followed, which were primarily located in shopping malls and shopping centers.

The new stores were a resounding success, and over the past ten years, Nina’s has been aggressively selling its older locations and opening suburban stores. The downtown area in many of Nina’s locations have been revitalized and are now filed with high-rise office buildings and upscale retail outlets, so downtown property values have skyrocketed. Thus, the sale of its old store properties resulted in large cash inflows to Nina’s. Since the company’s strategic plans call for it to lease the new suburban stores rather than to purchase them, the firm now has a “war chest” of excess cash.

Many alternative uses have been discussed for the excess cash, ranging from repurchases of stock or debt to higher dividend payments. However, management has decided to use the cash to make one or more acquisitions, since they believe an expansion would contribute the most to stockholders' wealth. One of the acquisition candidates is Chic, a chain of eleven stores which operates in northern Illinois. The issues now facing the company are (1) how to approach Chic's management and (2) how much to offer for Chic's stock.

Executives at Nina's are good at running retail clothing stores, but they are not finance experts and have no experience with acquisitions.  Bob Sharpe, the treasurer, has an accounting background, but he did attend a three-day workshop on mergers at Harvard University last year specifically to learn something about the subject. Nina's had no acquisition plans at that time; Sharpe just felt that it would be useful to become familiar with the subject.

Table 1 contains some basic data that Sharpe developed relating to the cash flows Nina's could expect if it acquired Chic. The interest expense listed in the table includes (1) the interest on Chic's existing debt, (2) the interest on new debt that Nina's would issue to help finance the acquisition, and (3) the interest on new debt that Nina's would issue over time to help finance expansion within the new division. The required retentions shown in Table 1 represent earnings generated within Chic that would be earmarked for reinvestment within the acquired company to help finance growth. Note too that all the estimates in Table 1 are the incremental flows Chic is expected to produce and to make available to Nina's if it is acquired. Although specific estimates were only made for 1993 through 1996, the acquired company would be expected to grow at a 5 percent rate in 1997 and beyond.

Table 1

Incremental Cash Flows to Nina’s if Chic is Acquired






Net sales

Cost of goods sold (50% of sales)


Selling/admin. expense

Interest expense




























Chic currently finances with 40 percent debt; it pays taxes at a 30 percent federal-plus-state tax rate; and its beta is 1.2. If the acquisition takes place, Nina's would increase Chic's debt ratio to 50 percent, and consolidation, coupled with expected earnings improvements, would move Chic's federal-plus-state tax rate up to that of Nina's, 40 percent.

One part of the analysis involves determining a discount rate to apply to the estimated cash flows. Bob Sharpe remembers from the Harvard workshop that Professor Robert Hamada had developed some equations that can be used to unlever and then relever betas, and Sharpe believes that these equations may be helpful in the analysis:


Formula to unlever beta:         


Formula to relever beta:             


Here, bU is the beta that Chic would have if it used no debt financing, T is the applicable corporate tax rate, and D/S is the applicable market value debt-to-equity ratio. Sharpe notes that the T-bond rate is 10 percent, and a call to the company's investment bankers produced an estimate of 6 percent for the market risk premium.

Assume that you were recently hired as Bob Sharpe's assistant, and he has asked you to answer some basic questions about mergers as well as to do some calculations pertaining to the proposed Chic acquisition. Then, you and Sharpe will meet with the board of directors, and it will decide whether or not to proceed with the acquisition, how to start the negotiations, and the maximum price to offer. As you go through the questions, recognize that either Sharpe or anyone on the board could ask you follow-up questions, so you should thoroughly understand the implications of each question and answer. Your predecessor was fired for "being too mechanical and superficial," and you don't want to suffer the same fate.


1)      Several factors have been proposed as providing a rationale for mergers. Among the more prominent ones are (1) tax considerations, (2) diversification, (3) control, (4) purchase of assets below replacement cost, and (5) synergy. From the standpoint of society, which of the reasons are justifiable? Which are not? Why is such a question relevant to a company like Nina’s, which is considering a specific acquisition? Explain your answers.

2)      Briefly describe the differences between a hostile merger and a friendly merger. Is there any reason to think that acquiring companies would, on average, pay a greater premium over target companies’ pre-announcement prices in hostile mergers than in friendly mergers?

3)      Use the data contained in Table 1 to construct Chic’s cash flow statements for 1993 through 1996. Why is interest expense typically deducted in merger cash flow statements, whereas it is not normally deducted in capital budgeting cash flow analysis? Why are retentions deducted in the cash flow statement?

4)      Conceptually, what is the appropriate discount rate to apply to the cash flows developed in Question 3? What is the numerical value? How much confidence can one place in this estimate; that is, is the estimated discount rate likely to be in error by a small amount such as 1 percentage point or a large amount such as 4 or 5 percentage points?

5)      What is the terminal value of Chic; that is, what is the 1996 value of the cash flows Chic is expected to generate beyond 1996? What is Chic’s value to Nina’s at the begininning of 1993? Suppose another firm was evaluating Chic as a potential acquisition candidate. Would they obtain the same value? Explain.

6)      A) Suppose Chic’s management has a substantial ownership interest in the company, but not enough to block a merger. If Chic’s managers want to keep the firm independent, what are some actions they could take to discourage potential suitors?

B) If Chic’s managers conclude that they cannot remain independent, what are some actions they might take to help their stockholders (and themselves) get the maximum price for their stock?

C) If Chic’s managers conclude that the maximum price they can get anyone to bid for the company is less than its “true value,” is there any other action they might take that would benefit both outside stockholders and the managers themselves? Explain.

D) Do Chic’s managers face any potential conflicts of interest in any of the situations presented in A through C? Explain and suggest what might be done to reduce the damage from conflicts of interest.



7)      Chic has 5 million share of common stock outstanding. The shares are traded infrequently and in small blocks, but the last trade, of 50 shares, was at a price of $1.50 per share. Based on this information, and on your answers to Questions 5 and 6, how much should Nina’s offer, per share, for Chic, and how should it go about making the offer?

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