Question

Happy Times, Inc., wants to expand its party stores into the Southeast. In order to establish an immediate presence in the area, the company is considering the purchase of the privately held Joe’s Party Supply. Happy Times currently has debt outstanding with a market value of $130 million and a YTM of 6 percent. The company’s market capitalization is $390 million, and the required return on equity is 11 percent. Joe’s currently has debt outstanding with a market value of $40 million. The EBIT for Joe’s next year is projected to be $15.8 million. EBIT is expected to grow at 10 percent per year for the next five years before slowing to 3 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 9 percent, 15 percent, and 8 percent, respectively. Joe’s has 1.85 million shares outstanding and the tax rate for both companies is 38 percent. Based on these estimates, what is the maximum share price that Happy Times should be willing to pay for Joe’s?

Answer 1

We need to firs calculate the value of firm through FCFF approach

Free cash flow to Firm = EBIT *( 1 - Tax rate ) - ( capital spending - depreciation + net working capital )

wacc = 130 *6*(1-0.38) / ( 130+390) + 390*11/(390+130) = 9.18

	Particulars	Year
	1	2	3	4	5	6
a	EBIT	15.8	17.38	19.118	21.0298	23.13278	23.82676
b	Tax	6.004	6.6044	7.26484	7.991324	8.790456	9.05417
c=a-b	NOPAT	9.796	10.7756	11.85316	13.03848	14.34232	14.77259
d	Capital Spending	2.37	2.607	2.8677	3.15447	3.469917	3.574015
e	Depreciation	1.264	1.3904	1.52944	1.682384	1.850622	1.906141
f	Net working capital	1.422	1.5642	1.72062	1.892682	2.08195	2.144409
g=d-e+f	Net Spending	2.528	2.7808	3.05888	3.364768	3.701245	3.812282
h=c-g	FCFF	7.268	7.9948	8.79428	9.673708	10.64108	10.96031
i	discounting factor	0.915919	0.838907	0.768371	0.703765	0.644591
g= h*i	Present value	6.656897	6.706894	6.757266	6.808017	6.859149

Terminal value = FCFF for year 6 / ( wacc - g) = 10.96031 / ( 0.0918 -0.03) =177.35

value of firm = presnet value of the fcff from year 1 to 5 + presnet value of terminal value

= 6.66+6.71 +6.76 + 6.81 + 6.86 + 177.35 /1.0918^5

=148.11

value of equity = value of firm - value 0f debt = 148.11 - 40 = 108.11

value per share = value of equity / no of shares = 108.11/ 1.85 = 58.44