Hastings Corporation is interested in acquiring Vandell Corporation. Vandell cur

Question

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell currently has a cost of equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is in common equity. Its federal-plus-state tax rate is 37%. After the acquisition, Hastings expects Vandell to have the following FCFs and interest payments for the next three years (in millions): Year1 Year 2 Year 3 FCF $10 $20 $25 Interest expense 28 24 20.28 After this, the free cash flows are expected to grow at a constant rate of 5%, and the capital structure will stabilize at 45% debt with an interest rate of 6.9%. What is the percentage cost of capital for the post-horizon period?

Year1

Year 2

Year 3

FCF

$10

$20

$25

Interest expense

28

24

20.28

Year1

Year 2

Year 3

FCF

$10

$20

$25

Interest expense

28

24

20.28

Explanation / Answer

Pre horizon

Debt = 25%

Equity= 75%

RE = RU + (RU -RD)* D/E *(1 - TC)

10% = RU +(RU-6%)*25%/75%*(1-37%)

10% = RU + 21%RU -0.0126

RU= 9.31%

Post horizon, cost of equity= 9.31% + (9.31%-6.9%)*45%/55%*(1-37%)= 10.55%

cost of capital for the post-horizon period = 45%*6.9%*(1-37%) + 55%*10.55%= 7.76%

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