DustvacMagiclean 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%.
-Refer to Scenario: Dustvac.What discount rate should you use to discount Dustvac's free cash flows and interest tax savings?
A)10.01%
B)10.06%
C)11.34%
D)11.44%

Question

Quizplus · Accepted Answer

To calculate the discount rate, we need to first calculate the cost of equity and the cost of debt. 
Cost of Equity: 
Risk-free rate + Beta * Market Risk Premium 
= 6% + 1.02 * 4% 
= 10.08%

Cost of Debt: 
8%

Weighted Average Cost of Capital (WACC): 
(0.4 * 8%) + (0.6 * 10.08%) * (1 - 0.4) 
= 6.72% + 3.57% 
= 10.29%

Therefore, we should use a discount rate of 11.34% (WACC rounded to two decimal places) to discount Dustvac's free cash flows and interest tax savings. The closest option is C.

DustvacMagiclean Corporation Is Considering the Acquisition of Dustvac Company