Description of this paper

On August 25, 1995, Warren Buffett, the CEO of Ber...

Description

Solution


Question

On August 25, 1995, Warren Buffett, the CEO of Berkshire Hathaway, announced that his firm would acquire the 49.5 percent of GEICO Corporation that it did not already own. The $2.3 billion deal would give GEICO shareholders $70.00 per share, up from $55.75 per share market price before the announcement. Observers were astonished at the 26 percent premium that Berkshire Hathaway would pay, particularly since Buffett proposed to change nothing about GEICO, and there were no apparent synergies in the combination of the two firms. At the announcement, Berkshire Hathaway?s shares closed up 2.4 percent for the day, for a gain in market value of $718 million. That day, the S&P500 Index closed up 0.5 percent. Conventional academic and practitioner thinking held that the more risk one took, the more one should be paid. Thus, discount rate used in determining intrinsic values should be determined by the risk of the cash flows being valued. The conventional model for estimating discount rates was the Capital Asset Pricing Model (CAPM) which added a premium to the long-term risk-free rate of return (such as the U.S. Treasury bond yield). Buffett departed from conventional thinking, by using the rate of return on the long-term (e.g., 30-year) U.S. Treasury bond to discount cash flows. Defending this practice, Buffett argued that he avoided risk, and therefore should use a ?risk-free? discount rate. His firm used almost no debt financing. Some analysts sought to test the suitability of Buffett?s $70 per share offer for GEICO using the discounted cash flow approach. Analysts used the Capital Asset Pricing model to estimate GEICO?s cost of equity. Value Line estimated GEICO?s beta at 0.75. The equity market risk premium was about 5.5%. And the risk free rate estimated by the yield on the 30 year U.S. Treasury bond was 6.86%. On July 7, 1995, Value Line Investment Survey published a forecast of GEICO?s dividends and future stock price within a range of possible outcomes: Value Line Forecast Information Low End of Range High End of Range Forecasted Dividends 1996 $1.16 $1.16 1997 $1.25 $1.34 1998 $1.34 $1.55 1999 $1.44 $1.79 2000 $1.55 $2.07 Forecasted Stock Price in 2000 $90.00 $125.00 Conclusion Conventional thinking held that it would be difficult for Warren Buffett to maintain his record of 28 percent annual growth in shareholder wealth. Buffett acknowledged that ?A fat wallet is the enemy of superior investment results.? He stated that it was the firm?s goal to meet a 15 percent annual growth rate in intrinsic value. Would the GEICO acquisition serve the long-term goals of Berkshire Hathaway? Was the bid price appropriate? Questions a) If you believe in Buffett?s investment philosophy, what would be the appropriate discount rate to use in your analysis? b) If instead, you believe in the CAPM, what would be the appropriate discount rate to use? c) Based on Value Line?s forecast was Buffett?s offer of $70 per share for GEICO, justified? Support your answer based on your assumptions and calculations.

 

Paper#4210 | Written in 18-Jul-2015

Price : $25
SiteLock