Martin Technologies Inc., a large electronics company, is evaluating the possible acquisition of Columbia Electronics, a regional electronics company. Martin’s analysts project the following post-merger data for Columbia (in millions of dollars):
2015201620172018Net sales$300$425$475$550Selling and administrative expense40506075Interest25303540
Tax rate after merger35%Cost of goods sold as a percent of sales75%Beta after merger1.2000Risk-free rate4%Market risk premium5%Continuing growth rate of cash flow available to Martin4%
If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. Columbia currently has a capital structure of 40% debt, but Martin would increase that to 50% if the acquisition were made. Columbia, if independent, would pay taxes at 20%; but its income would be taxed at 35% if it were consolidated. Columbia’s current market-determined beta is 1.15, and its investment bankers think that its beta would rise to 1.2000 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 75% of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn-out equipment, so they would not be available to Martin’s shareholders. The risk-free rate is 4%, and the market risk premium is 5%.
What is the appropriate discount rate for valuing the acquisition?
% (to 4 decimals)
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