Question

Pizza Place, a national pizza chain, is considering purchasing a smaller chain, Western Mountain Chain. Pizza Place's analysts project that the merger will result in incremental cash flows of $1.5 million in Year 1, $2 million in Year 2, and $3 million in Year 3, $5 million in Year 4 In addition, Western's Year 4 cash flows are expected to grow at a constant rate of 5% after Year 4. Assume that all cash flows occur at the end of the year. The acquisition will be made immediately if it is undertaken. Western's post merger beta is estimated to be 1.5 and its post merger tax rate would be 40%. The risk free rate is 6% and the market risk premium is 4%. What is the value of Western Mountain Pizza to Pizza Place?

Answer 1

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 6 + 1.5 * (4)

Expected return% = 12

	WACC=	12.00%
Year	Previous year FCF	FCF growth rate	FCF current year	Horizon value	Total Value	Discount factor	Discounted value
1	0	0.00%	1.5		1.5	1.12	1.3393
2	1.5	0.00%	2		2	1.2544	1.59439
3	2	0.00%	3		3	1.404928	2.13534
4	3	0.00%	5	75	80	1.57351936	50.84145
	Long term growth rate (given)=	5.00%			Value of Enterprise =	Sum of discounted value =	55.91
Where
Total value = FCF + horizon value (only for last year)
Horizon value = FCF current year 4 *(1+long term growth rate)/( WACC-long term growth rate)
Discount factor=(1+ WACC)^corresponding period
Discounted value=total value/discount factor