Question
Chittenden is considering the acquisition of another firm in its industry. The acquisition is expected to increase Chittenden's free cash flow by $5 million the
Chittenden is considering the acquisition of another firm in its industry. The acquisition is expected to increase Chittenden's 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. Chittenden has negotiated a purchase price of $110 million. Chittenden has an equity cost of capital of
12.3%, a debt cost of capital of 8.5%, a tax rate of 40%, and continually adjusts its capital structure to maintain its current debt-to-equity ratio of 2.
a) Using the WACC method, if the acquisition has similar risk to the rest of Chittenden, what is the value of this deal?
Assume no change in the WACC as the company continually adjusts to a constant D/E ratio.
Post-tax WACC=E/(E+D)*Re + D/(E+D)*Rd*(1-Tc)=1/3*12.3%+2/3*8.5%*(1-0.4)=7.5%
To value the deal, calculate as a perpetuity with constant growth:
V = CF / (post-tax WACC - g) = $5m/(7.5%-4%) = $142,857,142.90
NPV = $142,857,142.90 - $110,000,000 = $32,857,142.90
Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200 million in cash and expects future free cash flows of $75 million per year. Management plans to use the cash to expand the firm's operations, which in turn will increase future free cash flows by 12%. Iota's cost of capital is 10% and assume that capital markets are perfect. a) What's the value of Iota if they use the $200 million to expand? (1 mark) value = 75*1.12 / 0.1 = $840 million
I would like to know why the first question's answer the free cash flow is not growing but in the second question free cash flow is growing 75*1.12 . please explain why.
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