Question

Happy Times, Inc., wants to expand its party stores into the Southeast. In order to establish an immediate presence in the area, the company is considering the purchase of the privately held Joe’s Party Supply. Happy Times currently has debt outstanding with a market value of $150 million and a YTM of 5 percent. The company’s market capitalization is $390 million and the required return on equity is 10 percent. Joe’s currently has debt outstanding with a market value of $31 million. The EBIT for Joe’s next year is projected to be $12 million. EBIT is expected to grow at 9 percent per year for the next five years before slowing to 2 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 8 percent, 14 percent, and 7 percent, respectively. Joe’s has 1.9 million shares outstanding and the tax rate for both companies is 30 percent.

a.

What is the maximum share price that Happy Times should be willing to pay for Joe’s? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

b.

After examining your analysis, the CFO of Happy Times is uncomfortable using the perpetual growth rate in cash flows. Instead, she feels that the terminal value should be estimated using the EV/EBITDA multiple. The appropriate EV/EBITDA multiple is 9. What is your new estimate of the maximum share price for the purchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Calculating Happy Times WACC:

WACC = (w(d) * k(d) * (1 - Tax rate)) + (w(e) * k(e))

Total capital = Debt + Equity = 150 + 390 = 540

w(d) = 150 / 540 = 0.2778 = 27.78%

w(e) = 390 / 540 = 0.7222 = 72.22%

k(d) = 5%

k(e) = 10%

Tax rate = 30%

WACC = (0.2778 * 0.05 * (1 - 0.3)) + (0.7222 * 0.1)

WACC = 0.0097 + 0.0722 = 0.08192 = 8.192%

	Year 1	Year 2	Year 3	Year 4	year 5	Terminal
EBIT	12	12 * 1.09 =13.08	13.08 * 1.09 = 14.25	14.25 * 1.09 = 15.54	15.54 * 1.09 = 16.939	16.939 * 1.02 = 17.2778
- Taxes (30% of EBIT)	(3.6)	(3.924)	(4.275)	(4.662)	(5.0817)	(5.1833)
Net Income	8.4	9.156	9.975	10.878	11.8573	12.0945
+ Depreciation (7% of EBIT)	0.84	0.9156	0.9975	1.0878	1.1857	1.2094
- Capex (14% of EBIT)	(1.68)	(1.8312)	(1.995)	(2.1756)	(2.3715)	(2.1489)
- NWC (8% of EBIT)	(0.96)	(1.0464)	(1.14)	(1.2432)	(1.3551)	(1.3822)
FCFF (NI + Dep - Capex - NWC)	6.6	7.194	7.8375	8.547	9.3164	9.7729
Terminal Cash flow					9.7729 / (0.08192 - 0.02) = 157.8311
PV of FCFF at 8.192%	6.6 / 1.08192 =6.1	7.194 / (1.08192)2 = 6.1458	7.8375 / (1.08192)3 = 6.1886	8.547 / (1.08192)4 = 6.2378	(9.3164 + 157.8311) / (1.08192)5 = 112.752

Total value of firm today = sum of PV of FCFF = 137.4242

Total value of equity = Value of firm - Value of debt = 137.4242 - 31 = 106.4242

Value of equity per share = Total value of equity / Number of shares = 106.4242 / 1.9 = $56.01 per share

a. Therefore, $56.01 is the maximum price which Happy Times should be willing to pay for Joe.

Joe'e EBITDA for year 1 = EBIT + Depreciation = 12 + 0.84

EBITDA for year 1 = 12.84

Applying the EV/EBITDA multiple of 9

Therefore, EV = 12.84 * 9 = 115.56

Equity value = EV - Debt value = 115.56 - 31

= 84.56

b. Equity value per share = maximum price per share = 84.56 / 1.9 = $44.5053 per share