26-5 Merger Analysis Marston Marble Corporation is considering a merger with the Conroy Con- crete Company. Conroy is publicy traded company, and its betais 1.30 Conroy has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. In addition, it uses little debt: its target ratio is just 25, with the cost of debt 9 If the acquisition were made, Marston would operate Contoy as a sepa rate wholly owned subsidiary. Marston would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35 Marston also would Increase the debt capitalization in the Conroy subsidiary to w, = 40%, for a total of $22.27 million in debt by the end of Year 4, and pay 9.5 on the debt. Marston's acquisition department estimates that Conroy, if acquired. would generate the following free cash flows and interest expenses in mil- lions of dollars) in Years 1-5: 2013 May Chapter 26 Mergers and Corporate Control Year Free Cash Flows $1.30 Interest Expense $1.2 1 1.7 2 1.50 2.8 3 1.75 2.1 4 2.00 5 2.12 In Year 5. Conroy's interest expense would be based on its beginning-of- year (that is, the end-of-Year-4) debt, and in subsequent years both interest expense and free cash flows are projected to grow at a rate of 6. These cash flows include all acquisition effects. Marston's cost of equity is 10.5%, its beta is 1.0, and its cost of debt is 9.54. The risk-free rate is 6%. and the market risk premium is 4.5%. Use the compressed APV model to answer the following questions. a. What is the value of Conroy's unlevered operations, and what is the value of Conmoy's tax shields under the proposed merger and financing arrangements? b. What is the dollar value of Contoy's operations? Ir Conroy has $10 million in debt outstanding, how much would Marston be willing to pay for Conroy