Merger analysis Apilado Appliance Corporation is considering a merger with the V
ID: 2652487 • Letter: M
Question
Merger analysis
Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is 1.15. Vaccaro has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 30%.
If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Apilado also would increase the debt capitalization in the Vaccaro subsidiary to 50% of assets, which would increase its beta to 1.67. Apilado's acquisition department estimates that Vaccaro, if acquired, would produce the following net cash flows to Apilado's shareholders (in millions of dollars):
These cash flows include all acquisition effects. Apilado's cost of equity is 14%, its beta is 1.0, and its cost of debt is 9%. The risk-free rate is 5%.
What discount rate should be used to discount the estimated cash flows? (Hint: Use Apilado's rs to determine the market risk premium.)
Round your answer to two decimal places.
%
What is the dollar value of Vaccaro to Apilado? Round your answer to two decimal places. Enter your answer in millions. For example, an answer of $13,000,000 should be entered as 13.
$ million
Vaccaro has 1.5 million common shares outstanding. What is the maximum price per share that Apilado should offer for Vaccaro? Round your answer to the nearest cent.
$
Explanation / Answer
Calculation of Discount Rate:
For this we have to calculate Cost of Equity and for this we have to calculate Market Risk Premium:
Cost of Equity = rf + Beta (rm - rf)
Cost of Equity = 14%, Beta = 1, Risk Free Return (rf) = 5%, Market Risk Premium = X
14 = 5 + 1 (X - 5)
14 = 5 + X - 5
X = 14% So, Market Risk Premium = 14%
New Cost of Equity after Acquisition = 5 + 1.67 (14 - 5)
Cost of Equity = 20.03%
Calculation of Weighted Average Cost of Capital after Acquisition:
Proportion of Equity and Debt = 50:50
Cost of Equity = 20.03%
After Tax Cost of Debt = 9 x (1 - 0.35) = 5.85%
Weighted Average Cost = (Proportion of Equity x Cost of Equity) + (Proportion of Debt x Cost of Debt)
Weighted Average Cost of Capital = (0.50 x 20.03) + (0.50 x 5.85)
WACC = 12.94%
This WACC should be used as discount rate for Estimated cash Flow.