Question

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, $3.1 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 $9.56 million in debt (which has an 8% 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 $1.411 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 1.10 (i.e., based on its target capital structure). Vandell and Hastings each have a 25% combined federal-plus-state tax rate. The risk-free rate is 6% and the market risk premium is 4%.

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

a.Vandell’s pre-acquisition levered cost of equity

Using CAPM formula,

Levered Cost of equity=Risk-free rate+(Levered Beta*Market risk premium)

ie.6%+(1.1*4%)=

10.40%

Unlevered cost of equity

We need unlevered beta, to find Unlevered cost of equity

Unlevered beta=Levered beta/(1+((1-Tax rate)*Debt/equity))

ie.1.1/(1+((1-25%)*30/70))=

0.8324

Now,the Unlevered cost of equity with this Unlev. Beta is

ie.6%+(0.8324*4%)=

9.33%

b.Intrinsic unlevered value of operations at t = 0 (assuming the synergies are realized)

is the present value of the FCFs discounted at the above Unlevered cost

ie.(2.5/1.0933^1)+(3.1/1.0933^2)+(3.3/1.0933^3)+(3.52/1.0933^4)+((3.52*1.05)/(9.33%-5%)/1.0933^4)=

69.611973

millions

c. Value of the tax shields at t = 0

ie. Yearly (Interest payments* Tax rate) discounted to their PVs at the gross cost of debt, 8%

ie.(1.5*25%/1.08^1)+(1.5*25%/1.08^2+(1.5*25%/1.08^3)+(1.411*25%/1.08^4)+(1.411*1.05/(8%-5%)/1.08^4)=

37.525142

millions

d. Total intrinsic value of operations at t = 0 =

Intrinsic unlevered value of operations at t = 0 (as in b.)+Value of the tax shields at t = 0

69.611973+37.525142=

107.137115

millions

Value of Vandell's debt assumed (given)

107.137115*30%=                       (Target capital structure--30%)

32.141135

millions

so, value of Vandell's equity to Hastings =

107.137115-32.141135=

74.995980

Millions

Maximum price per share that Hasting’s should offer Vandell’s shareholders

Value of Vandell's Equity/No.of Equity shares o/s

No.of equity shares o/s= 1.5 millions (given)

ie. 74.995980/1.5=

49.99732

ie. $ 50 per share

ANSWERS --(all rounded to 2 digits)

Value of operations: $  107.14 million

Equity value to acquirer: $ 75.00  million

Maximum price: $ 50.00   per share