Question

Suppose that Ret is considering the acquisition of another firm in its industry for $100 million. The acquisition is expected to increase Ret’s free cash flow by $5 million the first year, and this contribution is expected to grow at a rate of 3% every year thereafter. Ret currently maintains a debt to equity ratio of 1, its corporate tax rate is 21%, its cost of debt rD is 6%, and its cost of equity rE is 10%. Ret will maintain a constant debt-equity ratio for the acquisition. The Free Cash Flow-to-Equity (FCFE) for the acquisition in year 1 is closest to _______. •

A. $6.5 million • B. $6.8 million • C. $4.1 million • D. $8.3 million

Answer 1

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Answer:

FCFE = CFO - Capex + New debt issued = -50M

As the company expects to maintain a growth rate of 3% yearly. and debt equity ratio has to be kept constant hence debt should be increased by 3% i.e. $50M * 3% = $1.5M

Interest of existing Debt = $50M * 6% = $3M

Interest after Tax = $3M * (1-21%) = $2.37M

CAsh from operating activity = $5M -$2.37M = $2.63M

FCFE = Cash from operating activites($2.63M) - Capital expenditure(0) + New debt issued($1.5M)

FCFE = $4.1M

Hence option C