Question

Problem 22-03 Merger Bid 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 1.60 (given its target capital structure). Vandell has $9.50 million in debt that trades at par and pays an 7% interest rate. Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% a year. Both Vandell and Hastings pay a 35% combined federal and state tax rate. The risk-free rate of interest is 7% and the market risk premium is 4%. Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.94 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 5% rate. Hastings plans to assume Vandell’s $9.50 million in debt (which has an 7% interest rate) and raise additional debt financing at the time of the acquisition. Hastings estimates that interest payments will be $1.6 million each year for Years 1, 2, and 3. After Year 3, a target capital structure of 30% debt will be maintained. Interest at Year 4 will be $1.422 million, after which the interest and the tax shield will grow at 5%. Indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition. Round your answers to the nearest cent. Do not round intermediate calculations. The bid for each share should range between $______ per share and $_______ per share.

Answer 1

Solution: Information given in the question:

About Vandell Corporation:

No. of equity shares: 1 million

7% Debt: $9.50 million

Free Cash Flow: $ 2 million and will grow @5% p.a.

Cost of euqity: Risk free rate of return + (Beta * Market risk premium)

= 7% + (1.6*4%) = 13.40%

Cost of Debt: Rate of Interest * (1-tax rate)

= 7%*(1-.35) = 4.55%

Cost of Capital: (Cost of euity * weightage of euity) + (Cost of Debt * Weightage of Debt)

=(13.40% * 70%) + (4.55% * 30%) = 10.745%

Details of Synergies:

Free Cash Flow:

Year 1: $0.5 milliion ($2.5 million - $2 million)

Year 2: $0.8 million ($2.9 million - $2.1 million)

Year 3: $1.195 million ($3.4 million - $2.205 million)

Year 4: $1.62475 million ($3.94 million - $2.31525 million)

and will grow @5% p.a. afterwards

Value of VANDELL CORPORATION before merger:

= Free Cash flow * (1+ growth rate) / (cost of capital - growth rate)

= $2 million * (1.05) / (10.745% - 5%)

= $36,553,525

Value of VANDELL CORPORATION after merger:

Year	Free Cash Flow	Interest (After Tax)	Free Cash Flow after interest	PVF	Present Value
1	2,500,000	1,040,000	1,460,000	0.90298	1,318,344
2	2,900,000	1,040,000	1,860,000	0.81536	1,516,578
3	3,400,000	1,040,000	2,360,000	0.73625	1,737,559
4	3,940,000	924,300	3,015,700	0.66482	2,004,895
			55,117,232 *	0.66482	36,642,989
					43,220,365

* Present value of Vandell's Cash Flows at the begining of 5th year or end of 4th year:

= Free Cash flow * (1+ growth rate) / (cost of capital - growth rate)

= 3,015,700 * (1.05) / (10.745% - 5%)

= $55,117,232

Minimum Share Value :

Value of Vandell Corporation's before merger / No. of equity shares

=  $36,553,525 / 1,000,000

= $ 37 per share

Maximum Share Value :

Value of Vandell Corporation's after merger / No. of equity shares

= $55,117,232 / 1,000,000

= $55

Summary:

Hastings Corporation is interested in buying Vandell Corporation. For the purpose of identfying the profitability of the deal and how much it should offer to Vandell's shareholders, it has made an analysis which consist the predicitons of future cost and earnings of Vandell Corporation before merger and after merger. After analyzing the data we can say that bid for each share should range between $37 per share and $55 per share.