Question

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell currently has 1 million shares outstanding and a target capital structure consisting of 30% debt; its current beta is 1.60 (i.e., based on its target capital structure). Vandell's debt interest rate is 7%. Assume that the risk-free rate of interest is 5% and the market risk premium is 6%. Both Vandell and Hastings face a 30% tax rate. Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.5 million, $3.1 million, $3.4 million, and $3.75 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 4% rate. Hastings plans to assume Vandell’s $8.42 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 $1.465 million, after which the interest and the tax shield will grow at 4%.

a. What is Vandell’s pre-acquisition levered cost of equity? What is its unlevered cost of equity? Round your answer to two decimal places. Do not round intermediate calculations.

Pre-acquisition levered cost of equity:____ %

Unlevered cost of equity:____ %

b. What is the intrinsic unlevered value of operations at t = 0 (assuming the synergies are realized)? Round your answer to the nearest cent. Do not round intermediate calculations. $ ____

c. What is the value of the tax shields at t = 0? Round your answer to two decimal places. Do not round intermediate calculations. $___ million

d. What is the total intrinsic value of operations at t = 0? What is the intrinsic value of Vandell’s equity to Hastings? What is Vandell’s intrinsic stock price per share? Round your answer to two decimal places. Do not round intermediate calculations.

Value of operations: $____ million

Equity value to acquirer: $____ million

Intrinsic value per share of existing shares to acquirer: $____ /share

Answer 1

Solution:

a) Vandell's pre-acquisition levered cost of equity = 5% + 1.6 * 6% = 14.6%
rSU = 7% * 0.3 +14.6% * 0.7 = 12.32%
b) Intrinsic unlevered value of operations:
	1	2	3	4
FCF ($ million)	2,500,000	3,100,000	3,400,000	3,750,000
pvif at 12.32%	0.8903	0.7927	0.7057	0.6283
PV of Horizon FCF	2,225,750	2,457,370	2,399,380	2,356,125
Cumulative PV of Horizon FCF	9,438,625
Terminal value of FCF = 3,750,000*1.04/(0.1234-0.04)				46,762,590
PV of terminal FCF=46,762,590*0.6283 =	29,380,935
Intrinsic unlevered value of operations	38,819,560
c) Value of tax shields:
Interest	1,600,000	1,600,000	1,600,000	1,465,000
tax shield at 35%	480,000	480,000	480,000	439,500
pvif at 12.32%	0.8903	0.7927	0.7057	0.6283
PV of Horizon tax shields	427,344	380,496	338,736	276,138
Cumulative PV of Horizon tax shields	1,422,714
Terminal value of FCF = 1,422,714*1.04/(0.1234-0.04)				17,741,278
PV of terminal tax shield =17,741,278 * 0.6283 =	11,146,845
Value of tax shields at t = 0	12,569,559
d) Total intrinsic value of operations	51,389,119
Value of debt	8,420,000
Equity value to acquirer	42,969,119
Number of shares	1,000,000
Intrinsic value per share of existing shares	$42.97