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Best Window & Door Corporation is considering the acquisition of Glassmakers Inc. Glassmakers has a capital...

Best Window & Door Corporation is considering the acquisition of Glassmakers Inc. Glassmakers has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Glassmakers' pre-merger beta is 1.36. Best's beta is 1.02, and both it and Glassmakers face a 40% tax rate. Best's capital structure is 40% debt and 60% equity. The free cash flows from Glassmakers are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

a.         What is Glassmakers' pre-merger WACC?

b.         What discount rate should you use to discount Glassmakers' free cash flows and interest tax savings?

c.         What is the value of Glassmakers' equity to Best?

Solutions

Expert Solution

Solution :-

(a)
Rf = 6%
Market Risk Premium = 4%
Pre merger Beta = 1.36
Now Ke = Rf + Beta ( Risk Premium) 6% + 1.36(4%) 11.44%
Kd ( Cost of Debt ) = 11%
Tax Rate = 40%
After tax debt cost = 11%(1-0.40) 6.60%
Particular Market Value Weights Cost (after tax) Weight*Cost
Equity 10000000 0.667 11.44% 7.63%
Bond 5000000 0.333 6.60% 2.20%
Total 15000000 WACC 9.83%

(b)

Post merger Beta 1.36
Rf = 6%
Market Risk Premium = 4%
Now Ke = Rf + Beta ( Risk Premium) 6% + 1.36(4%) 11.44%
Kd ( Cost of Debt ) = 11%
Particular Market Value Weights Cost (after tax) Weight*Cost
Equity 10000000 0.667 11.44% 7.63%
Bond 5000000 0.333 11.00% 3.67%
Total 15000000 WACC 11.29%

(c)

Value of Firm
Year FCF Tax Savings Net Cashflow [email protected]% PV of Cashflow
1 3000000 1000000 4000000 0.8986 3594213.32
2 3000000 1000000 4000000 0.8074 3229592.34
3 3000000 1000000 4000000 0.7255 2901960.95
4 3000000 1000000 4000000 0.6519 2607566.67
4 10000000 5000000 15000000 0.6519 9778350.00
Total 22111683.28
Now Value of Equity = Value of Firm - Value of Debt
= 22111683.28 - 5000000
Value of Equity 17111683.28

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