Question

12.03

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 1.50 (given its target capital structure). Vandell has $11.05 million in debt that trades at par and pays an 7.3% interest rate. Vandell’s free cash flow (FCF0) is $1 million per year and is expected to grow at a constant rate of 4% a year. Both Vandell and Hastings pay a 30% combined federal and state tax rate. The risk-free rate of interest is 3% and the market risk premium is 5%.

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 $3.53 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 $11.05 million in debt (which has an 7.3% 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 $1.480 million, after which the interest and the tax shield will grow at 4%. 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

We need to calculate the price Hasting can quate after taking into consideration the future benefit and growth. So we need to calculate the future cash flows to identify the benefit of hasting. After arriving the future value, we need to identify its present value. Based on which we can identify the bid price. To arrive at the present value we need to know the current cost of equity.

1.Cost of equity = Risk Free rate of Return + Beta× (market rate of return - risk free rate of return)

As per the question risk free rate of return =3%

Beta = 1.5

Market risk premium = (market rate of return - risk free rate of return) = 5%

So Cost of equity = 3%+(1.5×5%) = 10.5%

2. Now We need to calculate the future cash flows after synergy

Year	1	2	3	4
Free Cash Flow	2500000	2900000	3400000	3530000
Interest payment	1600000	1600000	1600000	1480000
Net Cash	900000	1300000	1800000	2050000
Present Value @ 10.5%	814479.6	1064679	1334092	1375006
Terminal Cash Flow on 4th year with increase in growth rate	PV*(1+growth rate)/(cost of Equity-growth rate)
	2050000*(1+0.04)/(10.5-0.04)
	203824.1
Present Value of Terminal Cash Flow	136711.9	ie (203824.10/(1.05)4)
Tatal Present Value Including Terminal Cash Flow	4724969	ie PV of all 4 Years in the above table +	136711.9
Bid value	44999705	ie 4724969/10.5%
So Bid for each Share should range between 44.9997 to 45	44.9997