Question

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt; its beta is1.35(given its target capital structure). Vandell has $9.85million in debt that trades at par and pays an 7.1% interest rate. Vandell’s free cash flow (FCF0) is $1million per year and is expected to grow at a constant rate of 4% a year. Both Vandell and Hastings pay a 40% combined federal and state tax rate. The risk-free rate of interest is5% and the market risk premium is4%. Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.6million, $2.8million, $3.3million, and $3.71million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 4% rate. Hastings plans to assume Vandell’s $9.85million in debt (which has an 7.1% interest rate) and raise additional debt financing at the time of the acquisition. Hastings estimates that interest payments will be $1.6million each year for Years 1, 2, and 3. After Year 3, a target capital structure of 30% debt will be maintained. Interest at Year 4 will be $1.416million, after which the interest and the tax shield will grow at 4%.

Indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition. Round your answers to the nearest cent. Do not round intermediate calculations.

The bid for each share should range between $ ________per share and $ _________per share.

Answer 1

First, we need to calculate the discount rate,ie .WACC to discount the free cash flows

WACC=(Wt.Equity*Cost Equity)+(Wt.Debt*Cost Debt)

AS per CAPM

Cost of Equity Ke= RFR+(beta*Mkt.risk premium)

Ke=5%+(1.35*4%)=

10.4%

&

After-tax cost of debt=Before-tax cost*(1-Tax rate)

ie. 7.1%*(1-40%)=

4.26%

Given the Wt.of debt =30% , Wt. of equity=(1-30%)=70%

WACC=(70%*10.4%)+(30%*4.26%)=

8.56%

Without synergy effect------------------------/Year	0	1	2	3	4
After-tax FCFs(1000000*(1-40%) growing at 4% /yr.		600000	624000	648960	674918
Horizon after-tax FCF(674918*1.04)/(8.56%-4%)					15392867
Interest tax shields(9850000*7.1%*40%)		279740	279740	279740	279740
Horozon int. Tax shield(279740/8.56%)					3267991
Total FCFs		879740	903740	928700	19615516
PV F at 8.56%(1/1.0856^Yr.n)		0.92115	0.84852	0.78161	0.71998
PV of FCFs at 8.56%		810372	766838	725882	14122786
NPV /Value of Vandell=	16425879
Less:Value of Vandell's Debt	9850000
Value of Vandell's Equity	6575879
No.of Common shares o/s	1000000
So, Price/share	6.58
With synergy effect-------------------------------/Year	0	1	2	3	4
After-tax FCFs(given FCF*(1-40%)		1560000	1680000	1980000	2226000
Horizon after-tax FCF(2226000*1.04)/(8.56%-4%)					50768421
Interest tax shields(given int.*40%)		640000	640000	640000	566400
Horozon int. Tax shield(566400*1.04)/(8.56%-4%)					12917895
Total FCFs		2200000	2320000	2620000	66478716
PV F at 8.56%(1/1.0856^Yr.n)		0.92115	0.84852	0.78161	0.71998
PV of FCFs at 8.56%		2026529	1968558	2047820	47863371
NPV /Value of Vandell=	53906279
Less:Value of Vandell's Debt	9850000
Value of Vandell's Equity	44056279
No.of Common shares o/s	1000000
So, Price/share	44.06
From the above 2 calculations--ie. Without synergy effect & with synergy effect,
The bid for each share should range between $ 6.58 per share and $ 44.06 per share.