Great Subs Inc.,a regional sandwich chain,is considering purchasing a smaller chain,Eastern Pizza,which is currently financed using 20% debt at a cost of 8%.Great Subs' 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.Eastern'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?
A)12.0%
B)13.9%
C)14.4%
D)16.0%

Question

Quizplus · Accepted Answer

First, we need to calculate the post-merger beta:

Post-merger beta = (1 + (1 - tax rate)*(debt/equity))*Eastern Pizza's pre-merger beta

Post-merger beta = (1 + (1-0.34)*(0.20/0.80))*2.0 = 2.38

Next, we can use the CAPM formula to calculate the appropriate rate for discounting:

Appropriate rate = risk-free rate + post-merger beta * market risk premium

Appropriate rate = 8% + 2.38*4% = 13.92%

Therefore, the best choice is B, 13.9%.