Question

Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers has determined that Fast Fruit's current cost of equity is 17.5%; Fast Fruit currently has no debt outstanding. In Year 1, Juicers expects Fast Fruit to generate $9 million in NOPAT and invest $50 million in total net operating capital. Fast Fruit will borrow to finance this expansion, with the first interest payment ($5 million) due at Year 2. (There will be no interest due at Year 1.) In Year 2, Fast Fruit will generate $25 million in NOPAT and invest $10 million in total net operating capital. Fast Fruit's marginal tax rate is 25%. After the second year, the free cash flows and the tax shields each will grow at a constant rate of 4%. Assume that all cash flows occur at the end of the year. If Juicers must pay $90 million to acquire Fast Fruit, what is the NPV of the proposed acquisition? (Report your answer in millions of dollars.

Answer 1

Answer:

Fast Fruit currently has no debt outstanding.

Unlevered cost of equity is =17.5%

Let us calculate free cash flow to equity (FCFE):

Year 1 FCFE = NOPAT - Increase in net operating capital = 9 - 50 = -$41 million

Year 2 FCFE = NOPAT - Increase in net operating capital + Interest * (1 - Tax rate)

= 25 - 10 - 5 * (1 - 25%)

= $11.25 million

After the second year, the free cash flows and the tax shields each will grow at a constant rate of 4%

Year 3 FCFE = (25 - 5 * (1 - 25%)) * (1 + 4%) = $22.10 million

Horizontal value at the end of Year 2= Year 3 FCFE /(Cost of equity- Growth %)= 22.10/(17.5% - 4%) = $163.7037M

Present Value of FCFEs = -41/1.175 + (11.25 + 163.7037) / 1.175^2 = $91.8270 million

NPV of the proposed acquisition = Present Value of FCFEs - Investment required

= 91.8270 - 90

= $1.8270 million

NPV of the proposed acquisition = $1.8270 million OR $1.83 million