A regional restaurant chain, Club Café, is considering purchasing a smaller chai

Question

A regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally's Sandwiches, which is currently financed using 25% debt at a cost of 8%. Club Café's analysts project that the merger will result in incremental free cash flows and interest tax savings of $2.5 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $127 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 to be undertaken. Sally's pre-merger beta is 2.0, and its post-merger tax rate would be 40%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

Explanation / Answer

cost of debt = 8%

after tax cost of debt = 8*(1-.4)= 4.8%

cost of equity = IRF + (Rm- IRF)* beta

market risk premium = 4% = (Rm- IRF)

cost of equity = 8 + (4)*2 = 16%

weighted average rate of return =

weight cost of source debt 0.2 4.8 0.96 equity 0.8 16 12.8 weighted average cost of capital 13.76 percent

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