Apilado Appliance Corp ( Show calculations) Question 4 [15 Marks] Aplado Apphanc

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Apilado Appliance Corp ( Show calculations)

Question 4 [15 Marks] Aplado Apphance Corporation is considernng a merger with the Vaccaro Vacuum Company Vaccaro is a publicty traded company, and its current beta is 130 Vaccaro has been barely profitable, so it has paid an average ol only 20% in taxes during the last several years In addition, t uses little debt, having a debt rato of just 25% If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary Aplado would pay taxes on a consolidated basis, and the tax rate would, therefore, increase to 35% Aplado also would increase the debt capitalisation in the Vaccaro subsidiary to 40% of assets, which would increase its beta to 1 47 Apilado's acquisition department estimates that Vaccaro, if acquired, would produce the folfowing cash flows to Apilado's shareholders (in millons of rands) Year Cash Flows R1 30 R1 50 R175 R2 00 5 and beyond Constant growth at 6% These cash flows include all acquisition effects Apilado's cost of equity is 14%, its beta is 1 0, and its cost of debt is 10% The nsk-free rate is 8%

Explanation / Answer

(a) The discount rate should be the cost of equity of Vaccaro since the cash flows being considered are residual cash flows to the equity holders. We will use CAPM, and we already have beta value (1.47) and risk free rate (8%). We need the market risk premium which we can calculate using the cost of equity of Apilado's cost of equity.

Apilado CoE : 14% = 8% + 1 * (market risk premium) or market risk premium = 6%

Hence Vaccaro CoE = 8% + 1.47 * 6% = 16.82%

(b) The value of Vaccaro will be discounted value of future cash flows at discount rate of 16.82%.

= 1.30/(1+16.82%) + 1.50/(1+16.82%)2 + 1.75/(1+16.82%)3 + 2/(1+16.82%)4 + [2/(16.82%-6%)]/(1+16.82%)4 = 14.31 million

(c) Since the value expected from this acquisition is 14.31 million, the firm should be willing to pay maximum = 14.31/1.2 = 11.92

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