Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac

Question

Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million bonds at after-tax cost of 11% and $10 million of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

What discount rate should you use to discount Dustvac's free cash flows and interest tax savings?

Explanation / Answer

For Dustvac D =$5 million rd= 11% E =$10 million beta is 1.36 Re = 6.0% + 1.36*4.0% =11.44% Dustvac's pre-merger WACC = 11.44%*$10/15 +60%*11%*$5/15 =9.83%

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