Creative Industries Inc. is contemplating an acquisition of Flagstaff, which is in a different industry from that of Creative. Creatives CFO is currently working on the valuation of Flagstaff. Flagstaff is expected to require some initial restructuring expenditure and is expected to have free cash flows of -$5 million in each of the first two years. The FCF from year three is expected to be +$8 million, and these are expected to grow at a rate of 4% per year thereafter. The estimated debt cost of capital for this acquisition is likely to be the same as Creatives current cost of debt of 7%, and both companies are in the 35% corporate tax bracket. Creative Industries intends to maintain a fixed debt-to-equity ratio of 1 after the acquisition. Creatives current debt-to-equity ratio is 0.6. Assume that interest payments are tax-deductible, but otherwise all Modigliani-Miller assumptions hold (i.e. there are no other frictions like bankruptcy costs). Also, assume that the risk-free rate is 4%, the expected market risk premium is 6%. Creative industries current equity beta is 1.6. Markum, a firm in the same industry as Flagstaff has an equity beta of 2 and a debt-to-equity ratio of 1. Calculate the cost of equity for this acquisition.

18%

14%

12%

16%