PAMPA RV, INC. Evaluation of an Investment Opportunity Pampa RV, Inc., a publicly traded firm, is considering the acquisition of Chico Clothing Company (CCC) for a price of $12 per share. CCC is a private company that specializes in manufacturing clothing, shoes and accessories for beauty pageant contestants. The RV business is slow, and Pampa's CFO believes that the acquisition of CCC will help to improve overall profitability and provide much needed cash flow. Pampa's has 500,000 shares of common stock outstanding, currently trading at $9.75 per share. The book value of the common stock is $5 per share. Pampa also has bonds with a market value of $3,500,000 and a yield to maturity of 3.4%. Based on current market valuations, Pampa is currently achieving its target debt to equity ratio. Pampa's equity beta is 0.80. CCC is a private firm that was founded ten years ago by four sisters, who have a combined 100 years of experience in the beauty pageant business as competitors, judges, and coaches. CCC's cost of goods sold (COGS) is expected to be 38% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 12% of revenues. These estimates are in line with the firm's historical performance, which is expected to continue for the foreseeable future. The firm is 100% equity financed and has 100,000 shares of common stock outstanding. Its equity beta is estimated to be 1.353. CCC has experienced rapid growth over the last ten years. However, your analysis of industry structure suggests that competition in the beauty pageant clothing and accessories market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows after five years will be a modest 1.5% per year. Your team has been hired as consultants to Pampa RV to evaluate the proposed acquisition of CCC. Tables 1 and 2 below contain additional data that you have collected during your research. The corporate tax rate is 40% for all firms. Table 1 Forecast Data for Chico Clothing Company Year 1 Year 2 Year 3 Year 4 Year 5 Sales Revenue 300,000 335,000 375,000 410,000 575,000 Investment in CapEx and NWC 18,000 25,000 40,000 50,000 65,000 Depreciation1 15,000 30,000 40,000 52,000 60,000 1The depreciation numbers listed above are not included in COGS percentage estimates. Table 2 Market Data Current yield to maturity on 30 year treasury bonds 2.50% Estimate of expected average return on the S&P 500 over the next 30 years 7.50%

QUESTION

4) Estimate the beta of the combined entity (Pampa + CCC) after the merger. Based on your answer, will the merged firm's cost of capital to be higher or lower than Pampa's current cost of capital? Explain your answer. Hint: Firm beta is a value-weighted average of individual betas