Question

Hasting 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 1.4 (given its target capital structure). Vandell has $10.19 million in debt that trades at par and pays an 8% interest rate. Vandell’s current free cash f low (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% 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 5%, and the market risk premium is 6%. Hasting’s first step is to estimate the current intrinsic value of Vandell. a. What is Vandell’s cost of equity? b. What is its weighted average cost of capital? c. What is Vandell’s intrinsic value of operations?

Answer 1

Summary of the question is,

Capital Structure :

Equity = 70%, Debt = 30%

Beta : 1.4

Debt : $10.19 Million @8% Interest Rate

Free Cash Flow : $ 2 Million per year, Expected growth rate : 5% p.a.

Tax Rate : 25%

Risk Free Rate: 5%

Market Risk Premium : 6%

CALCULATIONS FOR ABOVE ASKED QUESTIONS ARE:

(a) Vandell's Cost of Equity = Risk Free Rate + Beta * (Market Risk Premium Rate)

= 5 + 1.4(6)

= 13.4 %

(b) Vandell's Weighted Average Cost of Capital  

= (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)

= (%30 * 6% ) + (70%* 13.4%)

= 11.18 %

Working :Cost of Debt After Tax = Interest Rate * (1 - Tax Rate)

= 8 * (1-.25) = (8 * .75)

= 6 %

(c) Vandell’s Intrinsic Value of Operations =

We will use, Constant Growth Rate Model by discounting WACC @11.18% with the growth rate of 5% p.a.

= {Free Cash Flow * (1 + Growth Rate )} / (WACC - Growth Rate)

= {$20,00,000 * (1 + .05)} / (11.18% - 5%)

= $21,00,000 / 6.18%

= $ 3,39,80,583

Therefore, Value of Firm = $ 3,39,80,583

Now, Value of Debt : $1,01,90,000

So, Value of Equity = Value of Firm - Value of Debt

= $ 3,39,80,583 - $1,01,90,000

= $ 2,37,90,583

No. of Equity Shares Outstanding = $ 15,00,000

So, Intrinsic Value of Operations Per Share = Value of Equity / No. of Equity Shares Outstanding

= $ 2,37,90,583 / $ 15,00,000

= $ 15.86

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