Question

Hastings Corporation is interested in acquiring Vandell s Corporation. Vandell has 1 million shares outstanding and target capital structure consisting of 30% debt. Vandell’s has 10.82 million in debt that trades at par and pays an 8% interest rate. Assume that the risk free rate of interest is 5% and market risk premium is 6%. Both Hastings and Vandell’s face a 40% tax rate.

1. Vandell’s Free Cash Flow is $2 million per year and expected to grow at a constant rate of 5% a year; its beta is 1.4. What is the value of Vandell’s operation? If Vandell has 10.82 million in debt, what is the current value of Vandell’s stock? ( Use the corporate valuation model)

2. Hastings estimates that if it acquires Vandell, interest payments will be $1,500,000 per year for 3 years, after which the current target capital structure of 30% debt will be maintained. Interest in the fourth year will be $1.472 million, after which interest and the tax shield will grow at 5%. Synergies will cause the free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million in Years 1 through 4 respectively, after which the free cash flows will grow at a 5% rate. What is the unlevered value of Vandell, and what is the value of its tax shields? What is the per share value of Vandell to Hastings Corporation? Assume that Vandell now has $10.82 million in debt.

3. On the basis of your answers to Problems 1 and 2, indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition.

Answer 1

1. Free cash flow = $2 mn

Growth rate =5%

Beta = 1.4

Risk free rate = 5%

Market risk premium = 6%

Cost of equity = Risk free rate + Beta * Risk premium

rs = 5% + 1.4×6%

rs = 13.4%

Now wd= 30%, rd = 8%, T = 40%

WACC = wd*rd (1 - T) + ws * rs

= 0.30 (8%)(0.60) + 0.70 (13.4%)

= 10.82%

Value of VAndel operations Vops = FCF0 (1+g)/ (WACC - g) = $2.1 / (10.82% - 5%) = $36.08 million

Current value of Vandell stock = Vops - Debt = 36.08 - 10.82 = $ 25.26 million

Price Po = Current value of stock / outstanding shares = 25.26/ 1 million = $25.26 per share.

2. Intrest payment = 1.5 mn

Debt = 30%

Equity = 70%

Intrest payment = 1.472 mn

Horizon value = last yr tax shield × (1+g)/RSU -g

= 0.6 ×(1+0.05)/ 11.78% - 0.05 = $9.12 mn

Value tax shield = $7.67 mn ( divide each year tax shelter by 1+ RSU)

The unlevered value of the operations is equal to each years cash flows divided by 1+ RSU. Now the last yeartax shield horizon value

= last year FCF * (1+g) / RSU - g)

= $3.57 mn* (1+0.05)/ 11.78% - 0.05 = 55.29

Unlevered horizon value = $55.29 mn

Unlevered value of Vandell = $44.69 mn

Now Value of operations = 44.69 + 7.67 = $52.36 mn

Value to Harrisson = value of vandell operations - Vandell debt = 52.36 - 10.82 = $41.54 mn

Per share value to Harrison = value to harrisson/ outstanding shares = 41.54/ 1 mn = $ 41.54 per share

3. Based on the two answera, the range of prices could be anywhere from $ 25.26 per share to $41.54 per share.