My Subs, Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza,which is currently financed using 30% debt at a cost of 7%. Great Subs’ analysts project that the mergerwill result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes the horizon value of$107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern’s pre-mergerbeta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 4%, and the market riskpremium is 6%. What is the appropriate rate to use in discounting the free cash flows and the interesttax savings if you use the Adjusted Present Value approach?
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