Question

A regional restaurant chain, CoCo's, is considering purchasing a smaller chain, AJ's, which is currently financed using 20% debt at a cost of 8%. CoCo's analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. AJ's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings

Answer 1

13.856%

Step-by-step explanation:

For computing the discounting rate we have to find out the weightage average cost of capital but before that first we have to determine the cost of equity and the after tax cost of debt which is shown below:

Cost of equity = Risk free rate of return + Beta × market risk premium

= 8% + 2 × 4%

= 16%

And, the after cost of debt is

= Cost of debt × ( 1 - tax rate)

= 8% × (1 - 0.34)

= 5.28%

Now the weighted cost of capital is

= Cost of debt × weighted of debt + cost of equity × weighted of equity

= 5.28% × 20% + 16% × 80%

= 1.056% + 12.8%

= 13.856%