Question

A regional restaurant chain, Club Finance Rocks (CFR), is considering purchasing a smaller chain, AccountingIsOkToo Sandwiches (AIOT). The following post-merger data for the AIOT is projected. The values below are in millions. After the fourth year, the free cash flows and the tax shields will both grow at a constant rate of 4%. AIOT has $50 million of debt and $60 million of non-operating assets. Current stock price of the AIOT is $16 per share, with 12 million shares outstanding. Year 0 Year 1 Year 2 Year 3 Year 4 EBIT $32 $33 $37 $38 Tax Expense $3 $4 $4 $5 Total Operating Capital $16 $23 $32 $38 $45 Interest Expense $12 $14 $17 $20 Question: AIOT is currently financed using 20% debt at a cost of 8%. AIOT's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the expected market return is 12%. Using the Adjusted Present Value technique, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

A. 27.2%

B. 13.86%

C. 16%

D. 32%

E. 14.4%

Answer 1

Answer :- Option B). 13.86 %.

Explanation :- Cost of debt (after tax) = Before tax cost of debt * (1 - Tax rate).

= 8 % * (1 - 0.34)

= 5.28 %

Cost of equity = Risk free rate of return  + Beta * (Market return - Risk free rate of return).

= 8 % + 2.0 * (12 % - 8 %)

= 8 % + 2.0 * 4 %

= 8 % + 8 %

= 16 %

Appropriate discount rate = Cost of debt (after tax) * Weight of debt + Cost of equity * Weight of equity.

= 5.28 % * 0.20 + 16 % * (1 - 0.20)

= 1.056 % + 16 % * 0.80

= 1.056 % + 12.80 %

= 13.856 (Rounded off to 13.86 %)

Conclusion :- Discount rate to be applied for the discounting of cash flows = 13.86 % (Option B).