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Pep Boys’ Auto, a national auto parts chain, is considering purchasing a smaller chain, Tom’s Auto

Accounting

Pep Boys’ Auto, a national auto parts chain, is considering purchasing a smaller chain, Tom’s Auto. Pep Boys’ 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. Tom’s Auto is currently financed with 30% debt at a rate of 7%. The acquisition would be made immediately, if it is undertaken and Tom’s Auto 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. Tom's pre-merger beta is estimated to be 2.23, and its post-merger tax rate would be 30 percent. The risk-free rate is 1 percent, and the market risk premium is 6 percent. What is the value of Tom’s Auto’s equity to Pep Boys’ Auto? (Since the interest tax shields are not broken out separately, use the unlevered cost of equity to discount the incremental free cash flows). 

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