Question

Mr. Gatti’s Pizza, a regional pizza chain, is considering purchasing a smaller chain, CiCi’s Pizza, which is currently financed with 20 percent debt at a cost of 6%. Mr. Gatti's analysts project that the purchase will result in incremental free cash flows and interest tax savings. The acquisition would be made immediately, if it were undertaken. CiCi's pre-merger beta is estimated to be 2.1, and its post-merger tax rate would be 28 percent. The risk-free rate is 1 percent, and the market risk premium is 6 percent. What is the appropriate rate for a) discounting the free cash flows and b) the interest tax savings?

Answer 1

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

= 1% + 2.1(6%)

= 13.6%

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

= 13.6% * 80% + 6% * (1-0.28) * 20%

= 11.744%

WACC i.e. 11.744% rate should be used to discount the free cash flow and the interest tax savings both.

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