An equity buyout group intends to acquire Wedgewood Products (Wedgewood) as of the beginning of Year 8.

Question:

An equity buyout group intends to acquire Wedgewood Products (Wedgewood) as of the beginning of Year 8. The buyout group intends to finance 40 percent of the acquisition price with 10 percent annual coupon debt and 60 percent with common equity. The income tax rate is 40 percent. The cost of equity capital is 14 percent.

Analysts at the buyout firm project the following free cash flows for all debt and equity capital stakeholders for Wedgewood (in millions): Year 8, $2,100; Year 9, $2,268; Year 10, $2,449; Year 11, $2,645; and Year 12, $2,857. The analysts project that free cash flows for all debt and equity capital stakeholders will increase 8 percent each year after Year 12.

Required

a. Compute the weighted average cost of capital for Wedgewood based on the proposed capital structure.

b. Compute the total purchase price of Wedgewood (debt plus common equity). To do this, discount the free cash flows for all debt and equity capital stakeholders at the weighted average cost of capital. Ignore the midyear adjustment related to the assumption that cash flows occur, on average, over the year. In computing the continuing value, apply the 8 percent projected growth rate in free cash flows after Year 12 directly to the free cash flows of Year 12.

c. Given the purchase price determined in Part b, compute the total amount of debt, the annual interest cost, and the free cash flows to common equity shareholders for Year 8 to Year 12.

d. The present value of the free cash flows for common equity shareholders when discounted at the 14 percent cost of equity capital should equal the common equity portion of the total purchase price computed in Part b. Determine the growth rate in free cash flows for common equity shareholders after Year 12 that will result in a present value of free cash flows for common equity shareholders equal to 60 percent of the purchase price computed in Part b.

e. Why does the implied growth rate in free cash flows to common equity shareholders determined in Part d differ from the 8 percent assumed growth rate in free cash flows for all debt and equity capital stakeholders?

f. The adjusted present value valuation approach separates the total value of the firm into the value of an all-equity firm and the value of the tax savings from interest deductions. Assume that the cost of unlevered equity is 11.33 percent. Compute the present value of the free cash flows to all debt and equity capital stakeholders at this unlevered equity cost. Compute the present value of the tax savings from interest expense deductions using the pretax cost of debt as the discount rate.

Compare the total of these two present values to the purchase price determined in Part b.

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