Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02 , and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
-What Dustvac's pre-merger WACC?

Question

Quizplus · Accepted Answer

1. Calculate the cost of debt for Dustvac:

Dustvac's market value of debt = $5 million
Interest rate on debt = 11%
Tax rate = 40%

After-tax cost of debt = 11% x (1 - 0.40) = 6.6%

2. Calculate the cost of equity for Dustvac:

Dustvac's pre-merger beta = 1.36
Risk-free rate = 6.0%
Market risk premium = 4.0%

Cost of equity = 6.0% + 1.36(4.0%) = 11.44%

3. Calculate Dustvac's pre-merger WACC:

Market value of debt = $5 million
Market value of equity = $10 million
Total market value = $15 million

Weight of debt = $5 million / $15 million = 33.33%
Weight of equity = $10 million / $15 million = 66.67%

WACC = (0.3333 x 6.6%) + (0.6667 x 11.44%) = 9.83%

Therefore, the answer is (C) 9.83%.

As for the best choice(s), it is not provided what we are asked to choose.

Magiclean Corporation Is Considering the Acquisition of Dustvac Company