Great Subs, Inc., a regional sandwich chain, is considering purchasing a smaller

Question

Great Subs, Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 30% debt at a cost of 7%. Great Subs' 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 the horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern's pre-merger beta is 2.5, and its post-merger tax rate would be 34%. The risk-free rate is 3%, and the market risk premium is 7.5%. What is the appropriate rate to use in discounting the free cash flows and the interest tax savings if you use the Adjusted Present Value approach?

Explanation / Answer

Cost of equity = 3 + 2.5*(7.5-3) = 14.25 %

After tax cost of Debt = (1-0.34)*7 = 4.62 % ;

WACC = 0.3*44.62 + 0.7*14.25 = 11.361 %

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