Question

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.20 (given its target capital structure). Vandell has $8.00 million in debt that trades at par and pays a 7% interest rate. Vandell’s free cash flow (FCF₀) is $1 million per year and is expected to grow at a constant rate of 5% a year. Vandell pays a 30% combined federal and state tax rate. The risk-free rate of interest is 4%, and the market risk premium is 6%. Hasting’s first step is to estimate the current intrinsic value of Vandell.

1. What are Vandell’s cost of equity and weighted average cost of capital? Do not round intermediate calculations. Round your answers to two decimal places.

   Cost of equity:   %

   WACC:   %

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

   $   million

3. What is the current intrinsic value of Vandell’s stock? Do not round intermediate calculations. Round your answer to the nearest cent.

   $   / share

Answer 1

a. cost of equity = Risk-free rate + beta*market risk premium = 4% + 1.20*6% = 4% + 7.2% = 11.2%

WACC = weight of debt*after-tax cost of debt + weight of equity*cost of equity

after-tax cost of debt = before-tax cost of debt*(1-tax rate)

before-tax cost of debt is yield to maturity of debt. as firm's debt is trading at par, so its yield to maturity and coupon rate will be equal.

after-tax cost of debt = 7%*(1-0.30) = 7%*0.70 = 4.9%

firm's capital structure is 30% debt and 100% - 30% = 70% equity.

WACC = 0.30*4.9% + 0.70*11.2% = 1.47% + 7.84% = 9.31%

b. Intrinsic value of operations = FCF*(1+growth rate)/(WACC - growth rate) = $1 million*(1+0.05)/(0.0931 - 0.05) = $1 million*1.05/0.0431 = $1.05 million/0.0431 = $24.36 million

c. current intrinsic value of Vandell’s stock = (Intrinsic value of operations - value of debt)/no. of shares outstanding

current intrinsic value of Vandell’s stock = ($24.36 million - $8 million)/1 million = $16.36 million/1 million = $16.36 per share