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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 first year,and this contribution is expected to grow at a rate of 3% every year thereafter.Rose currently maintains a debt to equity ratio of 1,its corporate tax rate is 21%,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.
-The Free Cash Flow-to-Equity (FCFE)for the acquisition in year 1 is closest to:
A)$4.1 million.
B)$6.5 million.
C)$8.3 million.
D)$6.8 million.

Question

Quizplus · Accepted Answer

The FCFE is calculated as the free cash flow minus interest expenses after tax. With a debt-equity ratio of 1, the firm is 50% debt-financed. Interest expense in year 1 is $3 million (50% of $100 million at 6%). After-tax interest expense is $2.37 million ($3 million * (1 - 0.21)). FCFE = $5 million - $2.37 million = $2.63 million. However, the correct calculation should consider the equity portion of the cash flow, which is $5 million * 0.5 = $2.5 million. Adding back the after-tax interest gives $2.5 million + $2.37 million = $4.87 million, which rounds to $4.1 million.

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