Best Window & Door Corporation is considering the acquisition of Glassmakers Inc

Question

Best Window & Door Corporation is considering the acquisition of Glassmakers Inc. Glassmakers has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Glassmakers' pre-merger beta is 1.36. Best's beta is 1.02, and both it and Glassmakers face a 40% tax rate. Best's capital structure is 40% debt and 60% equity. The free cash flows from Glassmakers 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%.

Refer to Exhibit 26.1. What discount rate should you use to discount Glassmakers' free cash flows and interest tax savings?

10.01%

10.06%

11.29%

11.44%

13.49%

Explanation / Answer

After tax cost of debt = Rd x (1-t)

                                          = 11% x (1-0.40)

                                          = 6.60%

Cost of equity = Rf+ MRP x beta

                           = 0.06 + 0.04 x1.36

                           = 11.44%

Wd = 5/(5+10) = 0.33

We = 10/(1+10) =0.67

WACC = Wd x Kd + We x Ke

            = 0.33 x 6.60% + 0.67 x 11.44%

             = 9.84%

So 9.84% would be used to discount free cash flows.

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