Question

20

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 $170 million and a YTM of 8 percent. The company’s market capitalization is $410 million and the required return on equity is 13 percent. Joe’s currently has debt outstanding with a market value of $32 million. The EBIT for Joe’s next year is projected to be $15 million. EBIT is expected to grow at 7 percent per year for the next five years before slowing to 5 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 6 percent, 12 percent, and 5 percent, respectively. Joe’s has 2 million shares outstanding and the tax rate for both companies is 35 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 7. 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

1). WACC Calculation:

	Amount	Weight (Amount/Total)	Cost	Weighted cost (Cost*weight)
Debt	170	0.29	5.20%	1.52%
Equity	410	0.71	13.00%	9.19%
Total	580	1.00	WACC	10.71%

Note: cost of debt is after-tax: YTM*(1-tax rate) = 8%*(1-35%)

2). Calculation of Free Cash Flow to the Firm (FCFF) and then, equity value per share using the WACC of 10.71%

Formula	Year (n)	1	2	3	4	5	Perpetuity
7% p.a. growth for 5 yrs and 5% p.a. in perpetuity EBIT*(1+g)	EBIT	15.00	16.05	17.17	18.38	19.66	20.65
35%*EBIT	Tax	5.25	5.62	6.01	6.43	6.88	7.23
EBIT - Tax	Net income (NI)	9.75	10.43	11.16	11.94	12.78	13.42
5% of EBIT	Add:depreciation (D)	0.75	0.80	0.86	0.92	0.98	1.03
6% of EBIT	Working Capital (WC)	0.90	0.96	1.03	1.10	1.18	1.24
(Last year's WC - this year's WC	Less: Change in NWC (CWC)	-0.90	-0.06	-0.07	-0.07	-0.08	-0.06
12% of EBIT	Less: Capex	-1.80	-1.93	-2.06	-2.21	-2.36	-2.48
(NI + D + CWC + Capex)	Cash flows	7.80	9.25	9.89	10.59	11.33	11.92
CF in perpetuity/(WACC-perpetuity growth rate)	Terminal cash flow						208.5329
	FCFF	7.80	9.25	9.89	10.59	11.33	208.53
1/(1+WACC)^n	Discount Factor @WACC	0.903	0.816	0.737	0.666	0.601	0.601
FCFF*Discount factor	PV of FCFF	7.045	7.543	7.290	7.046	6.809	125.362
Sum of all PVs	Value of the firm	161.095
	Less: debt	-32
	Equity Value	129.10
	Number of shares O/S	2
Equity value/number of shares	Value per share	64.55

a). Happy Times should be willing to pay a maximum of $64.55 per share for Joe's.

b). Using EV/EBITDA multiple fo 7 for terminal cash flows:

Formula	Year (n)	1	2	3	4	5	Terminal
7% p.a. growth for 5 yrs and 5% p.a. in perpetuity EBIT*(1+g)	EBIT	15.00	16.05	17.17	18.38	19.66	20.65
35%*EBIT	Tax	5.25	5.62	6.01	6.43	6.88
EBIT - Tax	Net income (NI)	9.75	10.43	11.16	11.94	12.78
5% of EBIT	Add:depreciation (D)	0.75	0.80	0.86	0.92	0.98	1.03
6% of EBIT	Working Capital (WC)	0.90	0.96	1.03	1.10	1.18
(Last year's WC - this year's WC	Less: Change in NWC (CWC)	-0.90	-0.06	-0.07	-0.07	-0.08
12% of EBIT	Less: Capex	-1.80	-1.93	-2.06	-2.21	-2.36
(NI + D + CWC + Capex)	Cash flows	7.80	9.25	9.89	10.59	11.33
(Terminal EBIT + Dep.)	Terminal EBITDA						21.68
(Terminal EBITDA*EV/EBITDA multiple)	Terminal cash flow						151.74
	FCFF	7.80	9.25	9.89	10.59	11.33	151.74
1/(1+WACC)^n	Discount Factor @WACC	0.903	0.816	0.737	0.666	0.601	0.601
FCFF*Discount factor	PV of FCFF	7.045	7.543	7.290	7.046	6.809	91.221
Sum of all PVs	Value of the firm	126.954
	Less: debt	-32
	Equity Value	94.95
	Number of shares O/S	2
Equity value/number of shares	Value per share	47.48

Using the EV/EBITDA multiple, Happy Times can pay a maximum of $47.48 per share.