Wharton, Inc., a U.S. chain of upscale family restaurants, is considering making an offer to purchase Prim Aunties, Inc., a regional sandwich chain that is interested in expanding nationally. Assume it is year-end 2019 and the deal would be expected to close one year from now at year-end 2020. Prim Aunties’ free cash flow during 2020 is expected to be $20 million. Wharton feels that once it takes over at the end of 2020 it can increase Prim Aunties’ free cash flow by a total of 12% in 2021. Following 2021 the free cash flow is expected to grow at 4% annually in perpetuity. The two firms would typically be expected to have the same weighted average cost of capital (WACC). However, because Prim Aunties has recently carried too much debt on its balance sheet its WACC is currently 9%, as compared to an 8% WACC for Wharton. A. What cost of capital should be used to determine the value of Prim Aunties under Wharton’s ownership. Please explain your answer. B. What will be the total value of Prim Aunties to Wharton at the end of 2020?
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