Question

Merger Valuation with Synergies

Hastings Corporation is interested in acquiring Vandell Corporation. Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.5 million, $2.7 million, $3.3 million, and $3.52 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 $11.35 million in debt (which has a 7% interest rate) and raise additional debt financing at the time of the acquisition. Hastings estimates that interest payments will be $1.5 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 $1.484 million, after which the interest and the tax shield will grow at 5%. Vandell currently has 1.5 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 and Hastings each have a 30% combined federal-plus-state tax rate. The risk-free rate is 5% and the market risk premium is 6%.

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

   Pre-acquisition levered cost of equity:____ %

   Unlevered cost of equity: ____ %

2. What is the intrinsic unlevered value of operations at t = 0 (assuming the synergies are realized)? 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 the nearest cent.

   $ ____ million

3. What is the value of the tax shields at t = 0? 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. What is the total intrinsic value of operations at t = 0? What is the intrinsic value of Vandell’s equity to Hastings? What is the maximum price per share that Hasting’s should offer Vandell’s shareholders? Enter your answers for the value of operations and the equity value to acquirer 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 answers to two decimal places.

   Value of operations: $ ___million

   Equity value to acquirer: $ ___ million

   Maximum price: $ ____ per share

Answer 1

Part A
FCF0	$1	millions
Growth Rate (g)	5.00%
Risk Free Rate (Rf)	5.00%
Market Risk Premium MRP	6.00%
Beta	1.6
Cost of Debt RD	7.00%
Tax Rate	30.00%
Debt's Weight WD	30.00%
Equity's Weight (1-30%) WE	70.00%
Cost of equity RE = Rf + Beta x MRP ; 5%+1.60 x 6%	14.60%	a.pre-acquisition levered cost of equity
WACC = WE x RE + WD x RD x(1-Tax)
WACC = 70% x 14.60% + 30% x 7% x (1-30%)	11.69%	b.Unlevered cost of equity:
Value of Operation = FCF x (1+ g)/WACC -g
Value of Operation = $1,000,000 x (1+5%)/(11.69% - 5%)	$15.7	millions
Debt (Given)	$11.35	millions
Value of equity = Value of Operation - Value of Debt;($15.7 - $11.35)	$4.35	millions
Shares Outstanding	1	millions
Price = $4.35 million / 1 million shares	$4.35	per share
c) and d)
	In millions
FCF1	$2.5
FCF2	$2.7
FCF3	$3.3
FCF4	$3.52
Growth Rate	5.00%
WACC (calculated above)	11.69%
Horizon Value = FCF3 x (1+g)/WACC -g)
Horizon Value = $3.52 x (1+5%)/(11.69% -5%)	$55.25	Millions
Debt Interest	$1.5	millions
Debt Interest tax Shield = $1.5M x 30%	$0.45
Horizon value of Interest tax shield= Debt interest 4yr x(1+g)/WACC-g)
Horizon value of Interest tax shield = ($1.484x 30% x (1+5%))/(11.69%-5%)	$6.99	millions
Year	FCF	Tax Shield	FCF + Tax shield	PV @ 11.69%	Present Value
1	$2.5	$0.450	$2.95	0.8953	$2.64	Millions
2	$2.7	$0.450	$3.15	0.8016	$2.53	Millions
3	$3.3	$0.450	$3.75	0.7177	$2.69	Millions
4	$3.52	$0.445	$3.97	0.6426	$2.55	Millions
Horizon Value	$55.25	$6.987	$62.23	0.6426	$39.99	Millions
				Value of Operations	$50.40	Millions
Value of equity ( Equity value to acquirer )= Value of Operation - Value of Debt;($50.40 - $10.61)	$39.05	millions
Shares Outstanding	1	Millions
Price = $39.05 million / 1 million shares	$39.05	per share
The bid for each share should range between $4.35 and $39.05