TransWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld’s analysts project the following post-merger data for GCC (in thousands of dollars):

If the acquisition is made, it will occur on January 1, 2006. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40 percent debt, but TransWorld would increase that to 50 percent if the acquisition were made. GCC, if independent, would pay taxes at 20 percent, but its income would be taxed at 35 percent if it were consolidated. GCC’s current market determined beta is 1.40, and its investment bankers think that its beta would rise to 1.50 

if the debt ratio were increased to 50 percent. The cost of goods sold is expected to be 65 percent of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to TransWorld’s shareholders. The risk-free rate is 8 percent, and the market risk premium is 4 percent. 

a. What is the appropriate discount rate for valuing the acquisition?

b. What is the terminal value? What is the value of GCC to TransWorld?

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2006 2007 2008 2009 Net sales $450 $518 $555 $600 Selling and administrative 45 53 60 68 expense Interest 18 21 24 27 Tax rate after merger Cost of goods sold as a percent of sales Beta after merger 35% 65% 1.50 Risk-free rate 8% Market risk premium Terminal growth rate of cash flow 4% available to TransWorld 7%