Question

CAPITAL BUDGETING DECISION

Chittenden Corp. is considering the acquisition of another firm in its industry. The acquisition is expected to increase Chittenden’s free cash flow by $5 million the first year and this contribution is expected to grow at a rate of 4% per year from then on forever. The company has negotiated a purchase price of $110 million. Chittenden’s weighted average cost of capital is 7.5%. After the transaction, Chittenden will adjust its capital structure to maintain its current debt = 2/3 and equity = 1/3. The tax rate is 40%.

• 1. If the acquisition has similar risk to the rest of Chittenden, what is the value of this deal?

  2. Assume Chittenden proceeds with the acquisition. How much debt must Chittenden use to finance the acquisition and still maintain its debt-to-value ratio? How much of the acquisition cost must be financed with equity?

  3. Compute the value of the acquisition using the APV method, assuming Chittenden will maintain a constant debt-equity ratio for the acquisition. The unlevered cost of capital for a firm similar to this one is 9.77% and the interest rate on the debt is 8.5%.

Answer 1

Value of the asset acquired  = 5000000 / 7.5% - 4%

= $142857143

Therefore NPV = $110000000 - $142857143

= $32857143

Debt- Equity RATIO = 2

therefore debt is 2 / 3 i.e. 0667 (given)

so they should increase debt by = $142857143 x 66.67%

= $95242857

so reaming equity can be financed = 142857143 - 95242857

   = $47614285

  

Since we are already given with unlevered cost of capital = 9.77%

Vu = 5000000 / 9.77% - 4%

= $ 86.65 million

They have to add a debt of $95242857 so the interest on this @8.5% = $8.1 Million

TAX @40% = $3.24 ( 40% OF $8.1 Million)

PV = 3.24 / (9.77% - 4%)

  = $56.15

Value of levered firm VL = V_U + PV

=$86.65 + $56.15

= $142.8 Million

NPV FOR ACQUISITON = $142.8 Million - $110 Milliom

= $ 32.8 Million

Without the benefit of tax NPV WILL BE = $86.65 Million - $110 Million

= -$23.35 Million