Question

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1.5 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.20 (given its target capital structure). Vandell has $9.56 million in debt that trades at par and pays a 7.3% interest rate. Vandell’s free cash flow (FCF0) is $1 million per year and is expected to grow at a constant rate of 6% a year. Vandell pays a 25% combined federal-plus-state tax rate, the same rate paid by Hastings. The risk-free rate of interest is 3%, and the market risk premium is 6%. Hasting’s first step is to estimate the current intrinsic value of Vandell. What is Vandell’s cost of equity? Do not round intermediate calculations. Round your answer to two decimal places.

%

What is its weighted average cost of capital? Do not round intermediate calculations. Round your answer to two decimal places.

%

What is Vandell’s intrinsic value of operations? (Hint: Use the free cash flow corporate valuation model.) Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Do not round intermediate calculations. Round your answer to two decimal places.

$ million

Based on this analysis, what is the minimum stock price that Vandell’s shareholders should accept? Do not round intermediate calculations. Round your answer to the nearest cent.

Answer 1

Vandell’s cost of equity = risk-free rate + beta of stock*market risk premium = 3% + 1.20*6% = 3% + 7.2% = 10.2%

weighted average cost of capital = weight of debt*after-tax cost of debt + weight of equity*cost of equity

weight of debt is 30% in target capital structure. so weight of equity is 100% - 30% = 70%.

cost of debt is yield to maturity of the debt. as debt is trading at par, so debt's interest rate and its yield to maturity will be same. so, cost of debt is 7.3%.

after-tax cost of debt = cost of debt*(1-tax rate) = 7.3%*(1-0.25) = 7.3%*0.75 = 5.475%

weighted average cost of capital = 0.30*5.475% + 0.70*10.2% = 1.6425‬% + 7.14‬% = 8.78%

Vandell’s intrinsic value of operations = [free cash flow*(1+constant growth rate)]/(weighted average cost of capital - constant growth rate)

Vandell’s intrinsic value of operations = [($1 million*(1+0.06)]/(0.0878 - 0.06) = ($1 million*1.06)/0.0278‬ = $1.06‬ million/0.0278 = $38.13 million

minimum stock price that Vandell’s shareholders should accept = value of equity/no. of shares outstanding

value of equity = intrinsic value of operations - market value of debt = $38.13 million - $9.56 million = $28.57 million

minimum stock price that Vandell’s shareholders should accept = $28.57 million/1.5 million = $19.05 per share