'Wansley Portal Inc., a large Internet service provider, is evaluating the possible acquisition of Alabama Connections Company (ACC), a regional Internet service provider. Wansley's analysts project the following post merger data for ACC (in thousands of dollars):

'If the acquisition is made, it will occur on January 1, 2018. All cash flows shown in the income statements are assumed to occur at the end of the year.

ACC currently has a capital structure of 30 percent debt, which costs 9 percent, but Wansley would increase that to 40 percent debt, costing 10 percent if the acquisition were made.

ACC, if independent, would pay taxes at 30 percent, but its income would be taxed at 35 percent if it werre consolidated. ACC's current market-determined beta is 1.40. The cost of goods sold is expected to be 65 percent of sales, but it could vary somewhat.

Gross investment in operating assets is expected to be equal to depreciation, so net investment in operating assets will be zero. The risk-free rate is 7 percent, and the market risk premium is 6.5 percent. Wansley currently has $400,000 in debt outstanding.

a. What is the unlevered cost of equity? (show your work)

b. What is the horizon value of the tax shields and the unlevered operations? What is the value of ACC's operations and the value of ACC's equity to Wansley's shareholders?

Before we can proceed with this problem, we must generate pro forma income statements for ACC's operations after the proposed merger so we can calculate free cash flow and interest tax shields.

*In this scenario, we state that investment in net operating capital is zero. This arises from the fact that the only needed investments are those needed to replace worn out capital, and that they equal depreciation.

We must determine the tax shields.

From this point, we can derive horizon value from the basic DCF framework.

The tax shield is the interest multiplied by the post-merger tax rate.

To calculate the value of the tax shields add the horizon value of the tax shields to the 2022 tax shield to get the total tax shield cash flow in 2022. In the other years the total TS cash flow is just the annual TS.

Then find the NPV of this stream of tax shields at the unlevered cost of equity.

To calculate the unlevered value of operations you need the unlevered horizon value and the the annual free cash flows.

To calculate the unlevered horizon value, we just need the free cash flow for 2022.

To calculate the unlevered value of operations, add the unlevered horizon value to the free cash flow in 2022 to get the total unlevered cash flow in 2022. In the other years the unlevered cash flow is just the annual free cash flow. The unlevered value of operations is the NPV of the unlevered cash flows at the unlevered cost of equity.