Question

Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million. The acquisition is expected to increase Rose's free cash flow by $5 million the firs year, and this contribution is expected to grow at a rate of 3% every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is 6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.

51. The Free Cash Flow to Equity (FCFE) for the acquisition in year 0 is closest to:

a. $5 million

B. $100 million

C. -$100 million

D. -$50 milllion

52. The Free Cash Flow-to-Equity (FCFE) for the acquisition in year 1 is closest to:

A. $4.7 million

B. $6.5 million

C. $8.3 million

D. $6.8 million

Answer 1

51) The free cash to equity will be = Cash from operating activites - Capital expenditure + New debt issued

Hence = -$100Million + $50millions = -$50millions Option D

52)

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 * (1-40%) = $1.8M

CAsh from operating activity = $5M -$1.8M = $3.2M

FCFE = Cash from operating activites($3.2M) - Capital expenditure(0) + New debt issued($1.5M)

FCFE = $4.7M

Option A

and firm is going to maintain same debt equity ratio. hence Incremental value of debt will be $50Million