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 $120 million and a YTM of 6 percent. The company’s market capitalization is $340 million, and the required return on equity is 11 percent. Joe’s currently has debt outstanding with a market value of $29.5 million. The EBIT for Joe’s next year is projected to be $13 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 2.25 million shares outstanding and the tax rate for both companies is 38 percent.

a. What is the maximum share price that Happy Times should be willing to pay for Joe’s? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Maximum share price            $

After examining your analysis, the CFO of Happy Times is uncomfortable using the perpetual growth rate in cash flows. Instead, she feels that the terminal value should be estimated using the EV/EBITDA multiple. The appropriate EV/EBITDA multiple is 8.

b. What is your new estimate of the maximum share price for the purchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Maximum share price            $

Answer 1

Part a)

Step 1: Calculate WACC

The WACC can be arrived with the use of following equation:

WACC = Weight of Debt*After-Tax Cost of Debt + Weight of Equity*Cost of Equity

where

Weight of Debt = 120,000,000/(120,000,000 + 340,000,000)

Weight of Equity = 340,000,000/(120,000,000 + 340,000,000)

After-Tax Cost of Debt = 6%*(1-38%)

and Cost of Equity = 11%

Using these values in the above formula for WACC, we get,

WACC = 120,000,000/(120,000,000 + 340,000,000)*6%*(1-38%) + 340,000,000/(120,000,000 + 340,000,000)*11% = 9.10%

_____

Step 2: Calculate Annual Cash Flows

The annual cash flows are calculated with the use of following table:

	Cash Flows
	Year
	1	2	3	4	5
EBIT	13,000,000	14,300,000	15,730,000	17,303,000	19,033,300
Less Taxes (EBIT*38%)	4,940,000	5,434,000	5,977,400	6,575,140	7,232,654
Net Income	8,060,000	8,866,000	9,752,600	10,727,860	11,800,646
Add Depreciation (EBIT*8%)	1,040,000	1,144,000	1,258,400	1,384,240	1,522,664
Operating Cash Flow	9,100,000	10,010,000	11,011,000	12,112,100	13,323,310
Less Capital Spending (EBIT*15%)	1,950,000	2,145,000	2,359,500	2,595,450	2,854,995
Change in Working Capital (EBIT*9%)	1,170,000	1,287,000	1,415,700	1,557,270	1,712,997
Cash Flow from Assets	$5,980,000	$6,578,000	$7,235,800	$7,959,380	$8,755,318

_____

Step 3: Calculate Terminal Value of the Project and Total Present Value

The terminal value and total present value of the project is calculated as below:

Terminal Value of Project = Cash Flow Year 5*(1+Growth Rate)/(WACC - Growth Rate) = 8,755,318*(1+3%)/(9.10% - 3%) = 147,814,626.15

Now, we can calculate the total present value as follows:

Total Present Value = Cash Flow Year 1/(1+WACC)^1 + Cash Flow Year 2/(1+WACC)^2 + Cash Flow Year 3/(1+WACC)^3 + Cash Flow Year 4/(1+WACC)^4 + Cash Flow Year 5/(1+WACC)^5 + Terminal Value/(1+WACC)^5

Substituting values in the above formula, we get,

Total Present Value = 5,980,000/(1+9.10%)^1 + 6,578,000/(1+9.10%)^2 + 7,235,800/(1+9.10%)^3 + 7,959,380/(1+9.10%)^4 + 8,755,318/(1+9.10%)^5 + 147,814,626.15/(1+9.10%)^5 = $123,487,366.33

_____

Step 4: Calculate Maximum Share Price

The maximum share price is arrived as below:

Maximum Share Price = (Total Present Value - Market Value of Joe's Debt)/Number of Common Shares Outstanding = (123,487,366.33 - 29,500,000)/2,250,000 = $41.77 (answer for Part a)

_____

Part b)

Step 1: Calculate Revised Terminal Value

The revised terminal value is calculated as below:

Revised Terminal Value = (EBIT for Year 5 + Depreciation for Year 5)*EV/EBITDA Multiple = (19,033,300 + 1,522,664)*8 = $164,447,712

_____

Step 2: Calculate Total Present Value

The total present value is calculated as below:

Total Present Value = Cash Flow Year 1/(1+WACC)^1 + Cash Flow Year 2/(1+WACC)^2 + Cash Flow Year 3/(1+WACC)^3 + Cash Flow Year 4/(1+WACC)^4 + Terminal Value/(1+WACC)^5

Substituting values in the above formula, we get,

Total Present Value = 5,980,000/(1+9.10%)^1 + 6,578,000/(1+9.10%)^2 + 7,235,800/(1+9.10%)^3 + 7,959,380/(1+9.10%)^4 + 164,447,712/(1+9.10%)^5 = $128,583,750.03

_____

Step 3: Calculate Maximum Share Price

The value of maximum share price is arrived as below:

Maximum Share Price = (Total Present Value - Market Value of Joe's Debt)/Number of Common Shares Outstanding = (128,583,750.03 - 29,500,000)/2,250,000 = $44.04 (answer for Part b)