A regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally's Sandwiches, which is currently financed using 20% debt at a cost of 6%.
Club Café's 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.)
The acquisition would be made immediately, if it is to be undertaken. Sally's pre-merger beta is 2.0, and its post-merger tax rate would be 34%.
The risk-free rate is 4%, and the market risk premium is 5%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?