Question

Suppose an all-equity financed firm has a cost of capital of 9.5%. The firm is considering to invest in a new production facility to manufacture inputs for one of its core products, and has determined that the IRR of this investment equals 7.5%. Alternatively, the firm can acquire a supplier that makes the inputs. The acquisition would require an investment of $90 million and generate a free cash flow of $6.5 million indefinitely. The beta of both alternatives equals 0.9. The risk free rate equals 2% and the market risk premium is 5%. With this information, please answer the following two questions. Please show excel caluclations if any!

(i) What is the required return on both investment alternatives? Is investing in the new production facility attractive? And what about the acquisition?

(ii) Suppose the firm goes ahead and acquires the supplier. If we assume that market value of the supplier is 25% of the value of the combined firm, what would be the cost of capital of the company after the acquisition? Has the firm become more or less risky due to the acquisition?

Answer 1

Cost of capital of equity financed firm = 9.5%

Case 1 (When manufacture the inputs) :

IRR = 7.5%

Beta = 0.9

Required rate of return = cost of capital = 9.5%

Case 2 (Acquiring the suppliers) :

Investment = 90 million

Free cash flow = 6.5 million

Beta = 0.9

Risk Free rate = 2%

Market risk premium = 5%

Cost of Equity using CAPM formula = Risk free rate + Beta * Market risk premium

Cost of Equity = 2 + 0.9 * 5 = 6.5% = Required rate of return

i)

Required rate of return on case 1 (R1): 9.5%

Required rate of return on case 2 (R2): 6.5%

IRR = 7.5%

IRR < R1, so this alternative is not attractive and should not be taken

IRR > R2, so this alternative is not attractive and should be taken

ii) Cost of Capital = 6.5%

Free cash flow if supplier is acquired = 6.5 million for infinite period

Value of combined firm = Free cash flow / cost of capital

Value of combined firm = 6.5 / 0.065 = 100 million

Market value of supplier = 0.25 * 100 = 25 million

Cost of capital has decrease which means that firm has become less risky due to acquisition.

More the cost of capital, more the risk a firm carries