Question

ABC Inc. is considering investing in CGB. CGB's expected annual sales for the coming year are $10 million.. In addition, operating costs are 70% of sales, depreciation is 5% of sales (ignore CCA), and the required annual investment in equipment is 5% of sales. The tax rate is 35% and cash flows are expected to grow at 4% in perpetuity. ABS Inc plans to keep CGBs capital structure at 25% debt to value ratio. The appropriate cost of debt is 6%, and the equity beta of CGB is 1.715. Assume that the risk-free rate is 3% and the market risk premium is 7%.

Calculate the cost of capital for the project?
What is the max amount ABC should be willing to pay for CGB?

Grande drinks Inc is also considering acquiring CGB. The equity beta of Grande is 0.8 and its required return on debt is 5%. Grande is 40% finance with debt and it has 35% corporate tax rate. Calculate GD's cost of capital?

What is the max amount Grande drinks would be willing to pay for CGB? Assume Grande's forecast of CGB's cash flows and the estimates for the risks of business are the same as ABC's forecasts.

Answer 1

Dear student

Step 1 : Calculation of cash flows

Particulars	Cashflows
Sales	10000000
Less: Operating cost	(7000000)
Less: Depreciation	(500000)
Profit before tax	2500000
Less: Tax	(875000)
Net operating profit after tax (NOPAT)	1625000

Step 2: Calculation of Free Cashflow from Firm (FCFF)

Formula = NOPAT + Depriciation – CAPEX – Δ Net WC

Putting Value

=> FCFF = 1625000 + 500000 - 500000 - 0 [Capex = 5% * 10 Mn and Δ Net WC no information given]

=> FCFF = 1625000

Step 3: Calculation of Cost of Capital of ABC

Required rate of return on equity = Rf + Market Risk premium * Equity beta

   = 3 + 7 * 1.715

                                                     = 15.005 %

Cost of capital (WACC) = 25% * 6 + 75% * 15.005

                                      = 12.75 % Answer

Step 4: Calculation of Cost of Capital of Grande Drinks

Required rate of return on equity = Rf + Market Risk premium * Equity beta

   = 3 + 7 * 0.8

                                                     = 8.60 %

Cost of capital (WACC) = 40% * 5 + 60% * 8.60

                                      = 7.16 % Answer

Step 5: Maximum amount payable by both parties

Value of CGB = [FCFF (Expected for coming year) / (CoC - g) ]

> For ABC Inc.

Value = 1625000 / (0.1275 - 0.04)

   = $ 18571428.57 Answer

  

> For Grande Drinks

Value = 1625000 / (0.0716 - 0.04)

   = $ 51424050.63 Answer