The merger will result in incremental free cash flows

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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. Calculate the appropriate rate for discounting the free cash flows and the interest tax savings. Note that this rate is rEU. Hint: first, calculate cost of levered equity (rEL) using CAPM. Then calculate rEU as wDrD + wErEL.

 

Reference no: EM13705292

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