Martin Technologies Inc., a large electronics company, is evaluating the possibl

Question

Martin Technologies Inc., a large electronics company, is evaluating the possible acquisition of Columbia Electronics, a regional electronics company. Martin’s analysts project the following post-merger data for Columbia (in millions of dollars):

If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. Columbia currently has a capital structure of 40% debt, but Martin would increase that to 50% if the acquisition were made. Columbia, if independent, would pay taxes at 20%; but its income would be taxed at 35% if it were consolidated. Columbia’s current market-determined beta is 1.15, and its investment bankers think that its beta would rise to 1.2000 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 75% of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to Martin’s shareholders. The risk-free rate is 4%, and the market risk premium is 7%.

What is the appropriate discount rate for valuing the acquisition?
% (to 4 decimals)

2015 2016 2017 2018 Net sales $300 $425 $475 $550 Selling and administrative expense 40 50 60 75 Interest 25 30 35 40

Explanation / Answer

Appropriate discount rate for valuing the acquisition would be WACC of capital.

To calculate WACC, we will use beta and debt ratio values after merger. However, there is no information related to cost of debt (interest rate), which is required to find out WACC. So, we assume it to be 8%. (Replace it with the correct one and re-calculate based on below calculaton.)

Cost of debt will be after-tax interest rate.
After-tax intereset rate = 8% x (1-0.35) = 5.2%

Cost of equity: Rf + Beta*(Market Risk Premium)
=> 4% + 1.2*(7%) = 0.124 or 12.4%

WACC = (Wd x Rd) + (We + Ke) => (0.5 x 0.052) + (0.5 x 0.124) = 0.088 or 8.88%

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