In: Finance
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?
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 | |||||