# Business Case Study: Computech's Case

5155 Words 21 Pages
Register to read the introduction… Since interest expense has already been considered, the cash flows are equity flows, so they must be discounted using the cost of equity rather than the WACC. Also, the discount rate must reflect the riskiness of the flows, and these cash flows have CCI's business risk, not CompuTech’s business risk, plus its financial risk because interest has been deducted. Though, that the risk of the CCI Division is not the same as CCI’s risk if it operated independently, because the merger would lead to a change in CCI's leverage and its tax …show more content…
Note that the pre-merger tax rate and debt to equity ratio are used to unlever the beta. The resulting beta, 1.48, is the inherent beta of CCI's assets—if CCI had zero debt, and hence were unlevered, its beta would be 1.48. Next, this unlevered beta must be "relevered" to reflect the fact that the assets will be operated by CompuTech and will be financed with a debt ratio of 25 percent and subject to a tax rate of 40 percent: bL = bU[1 + (1 — T)(D/S] = 1.48[1+(0.6)(0.25/0.75)] = 1.48(1.2) = 1.78.
Thus, to obtain the required rate of return on equity, note that kRF = 6.5% and RPM = 5%. Thus, CCI Division's required rate of return on equity, which is the appropriate discount rate to apply to the merger cash flows, is 15.41%: ks(CCI) = kRF + (RPm)bCCI = 6.5% + (5%) 1.78 = 15.41%.
Although the discount rate was calculated to two decimal places, our confidence in its accuracy is low. First, CCI's market beta of 1.60 is merely an estimate of the true beta. Second, historical betas are not particularly good estimates of future market risk. Third, Hamada's equation requires all of the assumptions of the CAPM and of the Modigliani and Miller model, including no financial distress or agency costs. Thus, it can provide only a rough estimate of the effect of the acquisition on CCI's market risk. Finally, it is difficult to estimate the market risk premium at any point in