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    Pre and Post acquistion calculations

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    Teddy Bear Planet, Inc., is considering the acquisition of Sesame Street Co. The professionals from Goldman Sachs hired by Teddy Bear figured out that under the proposed plan, the IRR for this acquisition project is 15%. Moreover, assume the basic IRR rule applies here. The T-bill rate is 5%, and the market risk premium is 10%. The tax rate for Sesame Street is 35%

    Before acquisition: The Sesame Street equity Beta is 1.16, The Sesame Street also has the following market-value balance sheet:
    Cash: $150,000
    Non-cash assets: $50,000
    Debt: $100,000
    Equity: $100,000

    After acquisition: The Teddy Bear will propose an immediate debt retirement plan under which $90,000 cash is used to reduce debt by $90,000.
    (a) What is the Sesame Street's pre-acquisition cost of equity?
    (b) What is Sesame Street's unlevered equity Beta?
    (c) What is Sesame Street's equity Beta after acquisition?
    (d) What is the Sesame Street's post-acquisition cost of equity?
    (e) Under the proposed acquisition plan, is this acquisition a positive NPV project?

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    Solution Preview

    (a) What is the Sesame Street's pre-acquisition cost of equity?

    Using the CAPM equation, the cost of equity is
    Cost of Equity = Rf + (Rm-Rf) X beta
    Rf = T-Bill Rate = 5%
    (Rm-Rf) = Market Risk Premium = 10%
    Beta = 1.16
    Cost of equity = 5% + 10%X1.16 = 16.6%

    (b) What is Sesame Street's unlevered equity Beta?

    The current equity beta is the levered beta based on the given debt-equity ...

    Solution Summary

    The solutione explains how to calculate the cost of equity before and after acquisition and if the acquisiton is NPV positive.