Question 26 (20 marks) Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is 1.30. Vaccaro has been barely profitable. so it has paid an average of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 25 percent. If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35 percent. Apilado also would increase the debt capitalization in the Vaccaro subsidiary to 40 percent of assets, which would increase its beta to 1.47. Apilado's acquisition department estimates that Vaccaro, if acquired would produce the following Pre-tax cash flows 10 Apilado's shareholders: Year 1 2 3 4 5 and beyond Pre-tax Cash flows $2,000,000 $2,307,692.31 $2,692,307.69 $3,076,923.07 Constant growth at 6% These cash flows include all acquisition effects. Apilado's cost of equity is 14 percent, its beta is 1.0) and its cost of debt is 10 percent. The risk-free rate is 8 percent. a. What discount rate should be used to discount the estimated cash flows?(Hint: Use Apilado's Ks to determine the market risk premium). (4 marks) b. What is the terminal value? (3 marks) c. What is the dollar value of Vaccaro to Apilado? (13 marks) Question 26 (20 marks) Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is 1.30. Vaccaro has been barely profitable. so it has paid an average of only 20 percent in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 25 percent. If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35 percent. Apilado also would increase the debt capitalization in the Vaccaro subsidiary to 40 percent of assets, which would increase its beta to 1.47. Apilado's acquisition department estimates that Vaccaro, if acquired would produce the following Pre-tax cash flows 10 Apilado's shareholders: Year 1 2 3 4 5 and beyond Pre-tax Cash flows $2,000,000 $2,307,692.31 $2,692,307.69 $3,076,923.07 Constant growth at 6% These cash flows include all acquisition effects. Apilado's cost of equity is 14 percent, its beta is 1.0) and its cost of debt is 10 percent. The risk-free rate is 8 percent. a. What discount rate should be used to discount the estimated cash flows?(Hint: Use Apilado's Ks to determine the market risk premium). (4 marks) b. What is the terminal value? (3 marks) c. What is the dollar value of Vaccaro to Apilado? (13 marks)
