Question

In: Finance

BDI is looking to acquire a distressed pitchfork company. BDI is able to pay cash to...

BDI is looking to acquire a distressed pitchfork company. BDI is able to pay cash to fund the acquisition. The company president has asked you to evaluate the potential acquisition, and ultimately make a recommendation about wheather BDI should purchase the pitchfork company and if so, for what price. From your analysis and evaluation of the pitchfork company's financial statements, you put together the following table of sales forecasts (numbers in millions):

Pre-Merger Beta: 1.75

Pre-Merger % Debt: 35%

Pre-Merger Debt: $27.5 million

Pre-Merger Debt Rd: 9.5%

Tax Rate: 35%

2018 2019 2020
Net Sales 34.5 42.5
COGS (75%) 25.88 31.88
SG&A 2.25 2.5
Interest Expense 2.61 3.6

You also gathered the following market information:

Risk Free Rate 2.4%

Market Risk Premium 5.0%

Your study of the pitchfork market shows that with the merger and introduction of a new cardinal red and navy blue pitchfork sales will grow stongly for the next 2 years, but that overall the market is mature, and expected to grow at only a 2% constant rate after 2020. BDI would need to invest $500,000 in operating captial in 2019 to build the required inventory to start sales.

Deliverables:

1.) Complete an APV valuation analysis for the examined pitchfork company. 2.) Assume that the examined pitchfork company has 1.5 million shares outstanding. What is the maximum price BDI should pay per share? Would you recommend they offer this price (Pitchfork company stock price is $18.75 a share)? Why or why not? 3.) Given BDI's strong balance sheet, they could likely recapitalize the pitchfork company with 70% debt at the end of 2 years (this amounts to $75.5 million of debt at the end of 2020 at the same interest rate). What is the value of the pitchfork company's equity with this capital structure?

.

Solutions

Expert Solution

1.

After-tax cost of debt
9.5%*(1-35%)=
6.18%
Cost of Equity
As per CAPM,
RFR+(Beta*Market Risk Premium)
2.4%+(1.75*5%)=
11.15%
Calculating the Weighted Average Cost of capital of Pitchfork Co.
kWACC=(Wt. D*kD)+(Wt.E*kE)
ie.(35%*6.18%)+(65%*11.15%)=
9.41%
1. Enterprise value at WACC 2019 2020 Terminal value
Net Sales 34.5 42.5 42.5*1.02/0.0941-0.02)= 585.02
COGS (75%) 25.88 31.88 75%*585.02 438.77
SG&A 2.25 2.5 2.5*1.02/(0.0941-0.02)= 34.41
Interest Expense 0 0
6.37 8.12 111.84
Less Tax at 35% 2.23 2.84 39.14
After-tax cash flows 4.14 5.28 72.70
Adj. Present enterprise Value of Pitchfork=
-0.5+(4.14/1.0941^1)+(5.28/1.0941^2)+(72.7/1.0941^2)=
68.427148
ie. 68.43 millions
2. Equity Value at Cost of Equity 2019 2020 Terminal value
Net Sales 34.5 42.5 42.5*1.02/0.1115-0.02)= 473.77
COGS (75%) 25.88 31.88 75%*473.77 355.33
SG&A 2.25 2.5 2.5*1.02/(0.1115-0.02)= 27.87
Interest Expense 2.61 3.6 3.6*1.02/(0.1115-0.02)= 40.13
3.76 4.52 4.52*1.02/(0.1115-0.02)= 50.39
Less Tax at 35% 1.32 1.58 17.64
After-tax cash flows 2.44 2.94 32.75
Adj. Present Value of Pitchfork's equity =
-0.5+(2.44/1.1115^1)+(2.94/1.1115^2)+(32.75/1.1115^2)=
30.583906
millions
2..(Fig.in mlns.)
APV to Equity = 30.58
No.of shares o/s 1.5
Value per share(10.51/1.5) 20.39
So,intrinsic value per share= $20.39
whereas,
the market price per share= $18.75
indicating that the demand ,in the market for the company's stock is weak- it is undervalued in the market.
So,the maximum price BDI should pay per share= the market price $18.75
3… Value of Equity with 70% Debt 2019 2020 Terminal value
Net Sales 34.5 42.5 42.5*1.02/(0.1115-0.02)= 473.77
COGS (75%) 25.88 31.88 75%*473.77= 355.33
SG&A 2.25 2.5 2.5*1.02/(0.1115-0.02)= 27.87
Interest Expense 2.61 3.6 75.5*9.5%*1.02/(0.1115-0.02) 79.96
3.76 4.52 10.62
Less Tax at 35% 1.32 1.58 3.72
After-tax cash flows 2.44 2.94 6.90
Adj. Present Value of Pitchfork's equity =
-0.5+(2.44/1.1115^1)+(2.94/1.1115^2)+(6.9/1.1115^2)=
9.660055
millions
Value of Pitchfork's equity=
9.67   millions

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