CAPITAL BUDGETING DECISION

Chittenden Corp. is considering the acquisition of another firm in its industry. The acquisition is expected to increase Chittendens free cash flow by $5 million the first year and this contribution is expected to grow at a rate of 4% per year from then on forever. The company has negotiated a purchase price of $110 million. Chittendens weighted average cost of capital is 7.5%. After the transaction, Chittenden will adjust its capital structure to maintain its current debt = 2/3 and equity = 1/3. The tax rate is 40%.

• 1. If the acquisition has similar risk to the rest of Chittenden, what is the value of this deal?

  2. Assume Chittenden proceeds with the acquisition. How much debt must Chittenden use to finance the acquisition and still maintain its debt-to-value ratio? How much of the acquisition cost must be financed with equity?

  3. Compute the value of the acquisition using the APV method, assuming Chittenden will maintain a constant debt-equity ratio for the acquisition. The unlevered cost of capital for a firm similar to this one is 9.77% and the interest rate on the debt is 8.5%.