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 1.35 (given its target capital structure). Vandell has $10.76 million in debt that trades at par and pays a 7.1% interest rate. Vandell’s free cash flow (FCF₀) is $2 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 7%, and the market risk premium is 5%. Hasting’s first step is to estimate the current intrinsic value of Vandell.

1. What is Vandell’s cost of equity? Do not round intermediate calculations. Round your answer to two decimal places.

     %

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

     %

3. 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

4. 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

Question a:

Rf = Risk free rate = 7%

Rm-Rf = Market risk premium = 5%

Beta = 1.35

Cost of Equity = Rf + Beat * (Rm-Rf)

= 7% + (1.35 * 5%)

= 7% + 6.75%

= 13.75%

Therefore, Vandell's Cost of equity is 13.75%

Question b:

Wd = Weight of Debt = 30%

We = Weight of Equity = 70%

rd = Cost of debt = 7.1%

re = Cost of equity = 13.75%

t = tax rate = 25%

Weighted Average Cost of Capital = [Wd * rd * (1-t)] + [We * re]

= [30% * 7.1% * (1-25%)] + [70% * 13.75%]

= 1.5975% + 9.625%

= 11.2225%

Therefore, Weighted Average Cost of Capital is 11.22%

Question c:

FCF0 = Current Free Cash Flow = $2 million

g = growth rate = 6%

WACC = 11.22%

FCF1 = Expected Free Cash Flow = FCF0 * (1+g) = $2 million * (1+6%) = $2.12 million

Intrinsic Value of Operations = FCF1 / (WACC -g)

= $2.12 million / (11.22% - 6%)

= $2.12 million / 0.0522

= $40.6130268199 million

Therefore, Intrinsic Value of operations is $40.61 million

Question d:

Intrinsic Value of operations = $40.61 million

Shares Outstanding = 1.5 million

Minimum stock Price = Intrinsic Value of Operations / Shares Outstanding

= $40.61 million / 1.5 million

= $27.073333

Therefore, minimum stock price that Vandell’s shareholders should accept is $27.07