Question

A large pet-food manufacturer is considering buying a small boutique cat food business to add to their portfolio of pet foods. The head of the finance division has approached you to conduct a financial analysis to determine the most the firm should pay for the cat food business. The valuation of the cat-food business is based on cash flows of $180,500 per year over a five year period. The target business has the same risk as the firm’s overall operations. The cost of equity is 15 percent and the cost of debt is 3 percent on an after-tax basis. The firm’s capital structure consists of 10 million in equity and 8 million in debt. How would a change in the WACC change the amount the firm would be willing to pay for the cat food business?

Answer 1

1)	WACC at the exisitng capital structure = 15%*10/18+3%*8/18 =	9.67%
2)	Amount that the firm would be willing to pay at a WACC of 9.67% = 180500*(1.0967^5-1)/(0.0967*1.0967^5) =	$        6,90,045	Difference
3)	Amount that the firm would pay if WACC is raised by 1% point to 10.67% = 180500*(1.1067^5-1)/(0.1067*1.1067^5) =	$        6,72,685	$          -17,360
4)	Amount that the firm would pay if WACC is reduced by 1% point to 8.67% = 180500*(1.0867^5-1)/(0.0867*1.0867^5) =	$        7,08,135	$            18,090
	An increase in WACC will reduce the amount payable and an
	decrease in WACC will increase the amount payable.