Ace Appliance Corporation is considering a merger with the Vox Purification Systems Co. Vox is a publicly traded company, and its current beta is 1.2. Vox has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. Its debt ratio (to capital) is just 25%.
If the acquisition were made, Ace would operate Vox as a wholly owned subsidiary. Ace would pay taxes on a consolidated basis, increasing Vox tax rate to 40%. Ace also would increase the debt capitalization in the Vox subsidiary, which would increase its beta to 1.4. Ace’s acquisition department estimates Vox, if acquired, would produce the following additional cash flows to Ace’s shareholders (in millions of dollars):
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Get Help Now!| Year | Cash Flows |
| 1 | $1.10 |
| 2 | 1.30 |
| 3 | 1.60 |
| 4 | 1.90 |
| 5 and beyond | Constant growth at 7% |
Ace’s cost of equity is 14%, its beta is 1.0, and its cost of debt is 10%. The risk-free rate is 6%.
- What discount rate should be used to discount the estimates cash flows?
- What is the dollar value of Vox to Ace?
- Vox has 1.8 million common shares outstanding. What is the maximum price per share that Ace should offer for Vox?
- There are a lot of important assumptions in the above analysis. In one or two sentences each, list the two assumptions you believe are most important, explain why, and describe how you might sensitivity test these (you do not need to actually do the test).
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