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Pit Row Auto, a national auto parts chain, is considering purchasing a smaller
chain, Southern Auto. Pit Row’s analysts’ project that the merger will result in
incremental free cash flows and interest tax savings of $2 million in Year 1, $4
million in Year 2, $5 million in Year 3, and $117 million in Year 4. The Year 4
cash flow
includes
a horizon value of $107 million. Assume all cash flows occur at
the end of the year. Southern is currently financed with 30% debt at a rate of 10%.
The acquisition would be made immediately, if it is undertaken and Southern
would retain its current $15 million in debt and issue new debt in order to continue
targeting a 30% debt level. The interest rate will remain the same. Southern’s pre-
merger beta is estimated to be 2.0, and its post-merger tax rate would be 34
percent. The risk-free rate is 2 percent, and the market risk premium is 6 percent.
What is the value of Southern Auto’s equity to Pit Row Auto?
YearCashflows1$2,000,000.002$4,000,000.003$5,000,000.004$ 117,000,000.00Value of Southern AutoLess: Current debtValue of Southern Auto’s EquityNote-1 Disc factor Present value…
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