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Best Window & Door Corporation is considering the acquisition of Glassmakers Inc. Glassmakers has a capital...

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Finance

Best Window & Door Corporation is considering theacquisition of Glassmakers Inc. Glassmakers has a capital structureconsisting of $5 million (market value) of 11% bonds and $10million (market value) of common stock. Glassmakers' pre-mergerbeta is 1.36. Best's beta is 1.02, and both it and Glassmakers facea 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 millionfor each of the next 4 years and a horizon value of $5 million inYear 4. New debt would be issued to finance the acquisition andretire the old debt, and this new debt would have an interest rateof 8%. Currently, the risk-free rate is 6.0% and the market riskpremium is 4.0%.

a.         What isGlassmakers' pre-merger WACC?

b.         What discountrate should you use to discount Glassmakers' free cash flows andinterest tax savings?

c.         What is thevalue of Glassmakers' equity to Best?

Answer & Explanation Solved by verified expert
3.7 Ratings (622 Votes)

Solution :-

(a)
Rf = 6%
Market Risk Premium = 4%
Pre merger Beta = 1.36
Now Ke = Rf + Beta ( Risk Premium) 6% + 1.36(4%) 11.44%
Kd ( Cost of Debt ) = 11%
Tax Rate = 40%
After tax debt cost = 11%(1-0.40) 6.60%
Particular Market Value Weights Cost (after tax) Weight*Cost
Equity 10000000 0.667 11.44% 7.63%
Bond 5000000 0.333 6.60% 2.20%
Total 15000000 WACC 9.83%

(b)

Post merger Beta 1.36
Rf = 6%
Market Risk Premium = 4%
Now Ke = Rf + Beta ( Risk Premium) 6% + 1.36(4%) 11.44%
Kd ( Cost of Debt ) = 11%
Particular Market Value Weights Cost (after tax) Weight*Cost
Equity 10000000 0.667 11.44% 7.63%
Bond 5000000 0.333 11.00% 3.67%
Total 15000000 WACC 11.29%

(c)

Value of Firm
Year FCF Tax Savings Net Cashflow [email protected]% PV of Cashflow
1 3000000 1000000 4000000 0.8986 3594213.32
2 3000000 1000000 4000000 0.8074 3229592.34
3 3000000 1000000 4000000 0.7255 2901960.95
4 3000000 1000000 4000000 0.6519 2607566.67
4 10000000 5000000 15000000 0.6519 9778350.00
Total 22111683.28
Now Value of Equity = Value of Firm - Value of Debt
= 22111683.28 - 5000000
Value of Equity 17111683.28

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