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Homework Questions
Kansas City Deck Supply, a small residential builder of decks, is considering purchasing a lumber supplier (Midwest Pine). KC Deck’s analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Free cash flow | $1 | $3 | $3 | $7 |
| Unlevered horizon value | ||||
| Tax shield | 1 | 1 | 2 | 3 |
| Horizon value of tax shield | 32 |
Assume that all cash flows occur at the end of the year. Midwest Pine is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, Midwest Pine would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. Midwest Pine’s pre-merger beta is 2.0 and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of Midwest Pine to KC Deck?
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