You are trying to value synergy in a merger of Silverado Stores, a discount retail firm, and Zale Distributors, a jewelry retailer. The primary motivation for the merger is cost savings for the combined firm, and these savings are expected to amount to $ 10 million (pre-tax) next year (the first year after the merger) and grow 5% a year in perpetuity. Silverado has a beta of 1.20, market value of equity of $ 100 million and a market value of debt of $ 80 million. Zale has a beta of 1.30, a market value of equity of $ 150 million and a market value of debt of $ 50 million. Both firms have a pre-tax cost of debt of 7% and the tax rate is 30%; the firms plan no new debt issues after the merger. The riskfree rate is 5% and the market risk premium is 4%.

a. Estimate the cost of capital for the combined firm

b. Estimate the value of the synergy

2. You have been asked to compare two banks – Suntrust Banks and Southwest Banks. Suntrust has a market value of equity of $ 1.5 billion, a book value of equity of $ 750 million and is expected to earn 20% as its return on equity. Southwest Banks has a market value of equity of $ 1.00 billion and a book value of equity of $ 750 million. Both firms are in stable growth, growing at 5% a year, and the same cost of equity.

a. Assuming that Suntrust is correctly valued by the market, estimate the cost of equity for the bank.

b. Using the cost of equity estimated in part a, estimate the return on equity that Southwest Banks is expected to earn in the future. (You can assume that Southwest is correctly valued as well)