Exhibit 26.1
Best Window & Door Corporation is considering the acquisition of Glassmakers Inc. Glassmakers has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Glassmakers' pre-merger beta is 1.36. Best's beta is 1.02, and both it and Glassmakers face a 40% tax rate. Best's capital structure is 40% debt and 60% equity. The free cash flows from Glassmakers 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%.
-Refer to Exhibit 26.1.What is Glassmakers' pre-merger WACC?

Question

Quizplus · Accepted Answer

To calculate Glassmakers' pre-merger WACC, we need to first calculate the cost of debt and the cost of equity:

Cost of Debt:
Glassmakers' current debt is $5 million of 11% bonds, so their pre-tax cost of debt is 11%.

After-tax cost of debt = 11% * (1 - 40%) = 6.6%

Cost of Equity:
Glassmakers' pre-merger beta is 1.36, and we can use the CAPM formula to calculate their cost of equity:

Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 6.0% + 1.36 * 4.0%
Cost of equity = 11.44%

WACC:
Now we can calculate Glassmakers' pre-merger WACC:

WACC = (Cost of equity * Market value of equity / Total market value) + (Cost of debt * Market value of debt / Total market value)
WACC = (11.44% * $10 million / $15 million) + (6.6% * $5 million / $15 million)
WACC = 9.83%

Therefore, the answer is (C) 9.83%.

Exhibit 26.1 Best Window & Door Corporation Is Considering the Acquisition of Acquisition