Question

Great Subs Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 20% debt at a cost of 8%. Great Subs’ analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%.

Required:
What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

Answer 1

WACC 13.85600%

Step-by-step explanation:

First we calculate Eastern Pizza CAPM:

`Ke= r_f + \beta (r_m-r_f)`

risk free = 0.08

market rate = 0.12

premium market = (market rate - risk free) 0.04

beta(non diversifiable risk) = 2

`Ke= 0.08 + 2 (0.04)`

Ke 0.16000

Then we solve for WACC

`WACC = K_e((E)/(E+D)) + K_d(1-t)((D)/(E+D))`

Ke 0.16000

Equity weight 0.8

Kd 0.08

Debt Weight 0.2

t 0.34

`WACC = 0.16(0.8) + 0.08(1-0.34)(0.2)`

WACC 13.85600%

The company will use the data on eastern Pizza to evualuate project presented to it. Also, it will consider the new tax rate to determinate the tax shield.