Volunteer Pizza, a regional pizza chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed with 20 percent debt at a cost of 8%. Volunteer's 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 a horizon value of $107 million.) The acquisition would be made immediately, if it is undertaken. Eastern's pre-merger beta is estimated to be 2.0, and its post-merger tax rate would be 34 percent. The risk-free rate is 8 percent, and the market risk premium is 4 percent. What is the appropriate rate for discounting the free cash flows and the interest tax savings? Hint: First use the CAPM to calculate rEL
Possible Answers
A. 12.0%
B. 13.9%
C. 14.4%
D. 16.0%
E. None of the above
6.
For this and the next 3 questions: Pit Row Auto, a national auto parts chain, is considering purchasing a smaller chain, Southern Auto. Pit Row's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:
Year 1 2 3 4
FCF $1 $3 $3 $7
Unlevered horizon value $75
Interest tax savings $1 $1 $2 $3
Horizon value of interest tax savings $32
Assume all cash flows occur at the end of the year. Southern is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, if it is undertaken and Southern would retain its current $15 million in debt and issue new debt in order to continue targeting a 30% debt level. The interest rate will remain the same. Southern's pre-merger beta is estimated to be 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. Using the CAPM, calculate Southern Auto's cost of levered equity.
Possible Answers
A. 16%
B. 14.2%
C. 8%
D. None of the above
7.
Calculate Southern Auto's cost of unlevered equity.
Possible Answers
A. 16%
B. 14.2%
C. 8%
D. None of the above
8.
Calculate Southern Auto's value of operations.
Possible Answers
A. $53.401 million
B. $61.965 million
C. $64.641 million
D. $76.965 million
E. $79.645 million
9.
What is the value of Southern Auto's equity to Pit Row Auto?
Possible Answers
A. $53.401 million
B. $61.965 million
C. $64.641 million
D. $76.965 million
E. $79.645 million
10.
Kazeem Metals Company has a debt ratio of 30%. Interest rate on its debt is 9%. Its unlevered beta is 1.3 and tax rate is 40%. Suppose that the riskfree interest rate is 5% and the required rate of return on the market is 12%. Calculate Kazeem's cost of common equity (i.e. rEL). Hint: First use the Hamada equation (from your Capital Structure PP handout) to calculate levered beta (bL). Then with your levered beta, calculate rEL.
Possible Answers
A. 16.34
B. 15.89
C. 16.44%
D. 14.21%
E. None of the above
11.
Kazeem Metals Company has a debt ratio of 30%. Interest rate on its debt is 9%. Its unlevered beta is 1.3 and tax rate is 40%. Suppose that the riskfree interest rate is 5% and the required rate of return on the market is 12%. Calculate Kazeem's cost of unlevered equity (i.e. rEU).
Possible Answers
A. 16.34
B. 15.89
C. 16.44%
D. 14.21%
E. None of the above
12.
The Woodridge Hotels intends to acquire Wellington Resorts using new debt financing. The Woodridge estimates interest payments of $2 million dollars per year for 3 years after the acquisition. Expected free cash flows over the same period are $5 million, $6.5 million, and $8 million, respectively. Growth rate after this period is estimated to be 4%. Tax rate is 40%. Wellington's current WACC is 12% and unlevered cost of equity (rEU) is 15%. Wellington's capital structure will be different from its pre-merger capital structure if acquired by The Woodridge. Calculate the unlevered horizon value (UHV) of the free cash flows.
Possible Answers
A. $75.6364 million
B. $138.67 million
C. $61.4545 million
D. None of the above
13.
The Woodridge Hotels intends to acquire Wellington Resorts using new debt financing. The Woodridge estimates interest payments of $2 million dollars per year for 3 years after the acquisition. Expected free cash flows over the same period are $5 million, $6.5 million, and $8 million, respectively. Growth rate after this period is estimated to be 4%. Tax rate is 40%. Wellington's current WACC is 12% and unlevered cost of equity (rEU) is 15%. Wellington's capital structure will be different from its pre-merger capital structure if acquired by The Woodridge. Calculate the horizon value interest tax shield (HIVTS).
Possible Answers
A. $13.8667 million
B. $7.5636 million
C. $18.91 million
D. None of the above