Outback Adventure Co. is considering purchasing Hot Air Balloon Co. The direct a

Question

Outback Adventure Co. is considering purchasing Hot Air Balloon Co. The direct acquisition cost is $150 million, but the firm will need to raise finance by issuing new debt and equity with issuing costs of 10 million. Hot Air Balloon Co. will generate cash flows of $20 million in the first year and this will grow at 5% per year thereafter forever. Outback Adventure Co. have a WACC of 15%, while Hot Air Balloon Co. have a WACC of 10%. What discount rate should Outback Adventure Co. use to evaluate the purchase? What is the NPV of this acquisition? Should Outback Adventure Co. go ahead with this purchase?

Explanation / Answer

since Hot Air baloon co. is a part of outback co after acquisition so we will use WACC = 15% as discount rate

since it is a perpetuity

PV of cash flow = (cash flow in year 1)/(WACC-growth rate)

PV of positive cash flow = 20/(.15-.05) = $200 million

initial cost incurred = 150+10 = $160 million

NPV = -160+200 =$40 million

Yes it should go ahead

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