Problem:
Great Subs, Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 30% debt at a cost of 7%. Great Subs' analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes the horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern's pre-merger beta is 2.5, and its post-merger tax rate would be 34%. The risk-free rate is 3%, and the market risk premium is 7.5%.
Requirement:
Question: What is the appropriate rate to use in discounting the free cash flows and the interest tax savings if you use the Adjusted Present Value approach?
Note: Please provide equation and explain comprehensively and give step by step solution.