Great Subs Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 20% debt at a cost of 8%. Great Subs’ 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. Eastern's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%.
Required:
What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?
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