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Comfy Home Care Inc. is considering a merger with Mega Home Care Inc. Mega is a publicly traded company, and its current beta is 1.25.
Comfy Home Care Inc. is considering a merger with Mega Home Care Inc. Mega is a publicly traded company, and its current beta is 1.25. Mega has been barely profitable and had paid an average of 25% in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 30%. If the acquisition were made, Comfy would operate Mega as a separate, wholly owned subsidiary. Comfy would pay taxes on a consolidated basis, and the tax rate would therefore increase to 30%. Comfy also would increase the debt capitalization in the Mega subsidiary to 35% of assets, which would increase its beta to 1.60. Comfy estimates that Mega, if acquired, would produce the following net cash flows to Columbia's shareholders (in millions of dollars): \begin{tabular}{|r|r|} \multicolumn{1}{l|}{ Year } & Free Cash Flows to Equity \\ \hline 1 & $1.25 \\ \hline 2 & $1.40 \\ 3 & $1.70 \\ \hline 4 & $1.90 \\ \hline 5 and beyond & Constant growth at 5% \\ \hline \end{tabular} These cash flows include all acquisition effects. Comfy's cost of equity is 12%, its beta is 1.0, and its cost of debt is 8%. The risk-free rate is 5%. a. What discount rate should be used to discount the estimated cash flow? (Hint: Use Comfy's cost of equity to determine the market risk premium.) b. What is the dollar value of Mega to Comfy's shareholders
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