Best Window & Door Corporation is considering the acquisition of Glassmakers Inc
ID: 2770322 • Letter: B
Question
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 discount rate should you use to discount Glassmakers' free cash flows and interest tax savings?
10.01%
10.06%
11.29%
11.44%
13.49%
Explanation / Answer
After tax cost of debt = Rd x (1-t)
= 11% x (1-0.40)
= 6.60%
Cost of equity = Rf+ MRP x beta
= 0.06 + 0.04 x1.36
= 11.44%
Wd = 5/(5+10) = 0.33
We = 10/(1+10) =0.67
WACC = Wd x Kd + We x Ke
= 0.33 x 6.60% + 0.67 x 11.44%
= 9.84%
So 9.84% would be used to discount free cash flows.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.