A Case Study

You have the opportunity to visit SAP AG, the business software company. Based in Walldorf, Germany, SAP offers software development and implementation in application areas such as accounting, logistics and human-resource management to large businesses in Europe, North America and around the world. In 1997 the company had sales of over USD3.5 billion equivalent. In recent months the company's stock price has been depressed, and management is concerned about a leveraged buyout or a hostile takeover. Hence you have been asked to evaluate whether the company has an appropriate amount of debt. If it does raise additional debt, the proceeds will be used for a stock buyback.

You have collected the following information about SAP's current position:
Current share price: 772.2 DEM
Shares outstanding: 107 million
Beta of the stock based on the German DAX index: 1.15
Debt outstanding: 2,000 DEM million
Debt rating: A1/AAA
Market rate on bonds with rating AAA: 4.40%
Government bond rate: 4.00%
DAX long-run expected return 9.50%
Company's marginal tax rate: 44%

What is the firm's current debt/equity ratio?
What is SAP AG's current debt/capital ratio?
What is SAP's unlevered beta?
What is SAP's cost of equity? Its weighted average cost of capital?

Based on the company's business, its interest coverage and other factors, you have prepared a table showing what an increase in debt would do to the company's ratings and its cost of borrowing:
Additional debt(DEM mill.) New Rating Interest rate
10000 AA 4.850%
15000 A 5.100%
20000 BBB 8.500%
30000 BB 12%

How much additional debt should SAP take on, if the additional debt is used to purchase shares at the current market price?

What is SAP's weighted average cost of capital after the additional debt?

How much does SAP's value increase as a result of the lower cost of capital?
(Hint: we can assume that the additional value comes from the savings from a lower cost of capital each year, and that the savings will continue indefinitely.)
What will be the increase in the share price for SAP after the company takes on new debt?

Assume the company appears receptive to your advice. They now reveal that they are considering the acquisition of all the equity and debt of a similar, privately owned, French software services company, Services Digitales Francaises SA, which has long-term service contracts and a steady cash flow that will continue indefinitely, but which shows no growth prospects. The cost of the acquisition would be DEM 3000 million.

Summary financials of the French firm show the following (DEM million equivalent):

Revenues/year: 1000
Operating costs: 400 (This includes depreciation of 100)
EBIT: 600
Interest on debt: 100
Taxable income: 500
Tax at 36%: 180
After-tax profit: 320

What would be the free cash flows to the acquired firm, SDF, if SAP completes the acquisition?
What is the net present value of SAP's investment in SDF?

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