Magiclean Corporation Is Considering the Acquisition of Dustvac Company

question 4

Multiple Choice

Magiclean 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%.
-What discount rate should you use to discount Dustvac's free cash flows and interest tax savings?

• A) 10.01%
• B) 10.06%
• C) 11.29%
• D) 11.44%
• E) 13.49%

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Definitions:

Incremental Value

Incremental value refers to the additional or extra value generated by undertaking a specific action or investment compared to not doing so.

Merger Premium

The merger premium is the additional cost above the market price that a company pays to acquire another company, often reflecting the perceived future value of the target company.

Shares Outstanding

refers to the total number of shares of a corporation that are currently owned by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s insiders.

Market Price

The prevailing price at which a service or asset is being offered for sale or purchase.