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Giant Foods is trying to decide whether or not to buy Yummy Ice Cream. Yummy is...

Giant Foods is trying to decide whether or not to buy Yummy Ice Cream. Yummy is currently financed with 35% debt and 65% equity. Giant Foods intends to finance the acquisition mainly with debt such that the debt/equity ratio will be 1:1. If Yummy’s current equity beta is 1.4 and the new cost of debt is expected to be 13%, what discount rate (WACC) should Giant Foods use to value the acquisition? Assume the risk-free rate is 3%, the corporate tax rate is 25% and the expected market risk premium is 6%.

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Answer #1

  

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Cost of Equity = Rf + beta * (Rm - Rf)

= 3% + 1.4 * 6%

= 11.4%

Cost of Debt = 13%

After Tax Cost of Debt = 13% * (1-0.25) = 9.75%

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

= 11.4% * 50% + 9.75% * 50%

= 10.58%

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