Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 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 Conroy as a separate, 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 wd = 40%, for a total of $22.27 million in debt by the end of Year 4, and pay 9.5% on the debt. Marston%u2019 s acquisition department estimates that Conroy, if acquired, would generate the following free cash flows and interest expenses (in millions of dollars) in Years 1%u2013 5:

Year Free Cash Flows Interest Expense

1 $1.30 $1.2

2 1.50 1.7

3 1.75 2.8

4 2.00 2.1

5 2.12 ?

In Year 5, Conroy%u2019 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%u2019 s cost of equity is 10.5%, its beta is 1.0, and its cost of debt is 9.5%. The risk-free rate is 6%, and the market risk premium is 4.5%.

a. What is the value of Conroy%u2019 s unlevered operations, and what is the value of Conroy%u2019 s tax shields under the proposed merger and financing arrangements?

b. What is the dollar value of Conroy%u2019 s operations? If Conroy has $10 million in debt outstanding, how much would Marston be willing to pay for Conroy?