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Problem - Red Valley Breweries is considering an acquisition of Flagg Markets. Flagg currently has a cost of equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is in common equity. Its federal-plus-state tax rate is 25%. After the acquisition, Red Valley expects Flagg to have the FCFs and interest payments for the next 3 years (in millions) shown in the following table. After the explicit forecast period, the free cash flows are expected to grow at a constant rate of 5%, and the capital structure will stabilize at 35% debt with an interest rate of 7%. Use the compressed adjusted present value approach to answer the following questions.
Year 1
Year 2
Year 3
FCF
$10.00
$20.00
$25.00
Interest expense
28.00
24.00
20.28
Required -
a. What is Flagg's unlevered cost of equity? What are its levered cost of equity and cost of capital for the post-horizon period?
b. What is Flagg's value of operations to Red Valley?
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