American Pizza, a national pizza chain, is considering purchasing a smaller chai

Question

American Pizza, a national pizza chain, is considering purchasing a smaller chain, Eastern Pizza. American's analysts project that the merger will result in incremental net cash flows 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 terminal value of $107 million.) The acquisition would be made immediately, if it is undertaken. Eastern's post-merger beta is estimated to be 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 discount rate for valuing the acquisition?

Explanation / Answer

Discount rate (CAPM) = Rf+×Rp

Rf is risk free return

is beta of the security

Rp is risk premium

= 8%+2×4%

= 16%

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