Question

Problem 22-03
Merger Bid

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 1.55 (given its target capital structure). Vandell has $11.54 million in debt that trades at par and pays an 7.2% interest rate. Vandell’s free cash flow (FCF₀) is $2 million per year and is expected to grow at a constant rate of 5% a year. Both Vandell and Hastings pay a 35% combined federal and state tax rate. The risk-free rate of interest is 4% and the market risk premium is 7%.

Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.3 million, $3.2 million, $3.4 million, and $4.00 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 $11.54 million in debt (which has an 7.2% 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 $1.476 million, after which the interest and the tax shield will grow at 5%.

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

Part A						Problem 22-03
FCF0	2	millions				Merger Bid
Growth Rate (g)	5.00%					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 1.55 (given its target capital structure). Vandell has $11.54 million in debt that trades at par and pays an 7.2% interest rate. Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% a year. Both Vandell and Hastings pay a 35% combined federal and state tax rate. The risk-free rate of interest is 4% and the market risk premium is 7%.
Risk Free Rate (Rf)	4.00%					Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.3 million, $3.2 million, $3.4 million, and $4.00 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 $11.54 million in debt (which has an 7.2% 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 $1.476 million, after which the interest and the tax shield will grow at 5%.
Market Risk Premium MRP	7.00%					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.
Beta	1.55					The bid for each share should range between $ per share and $ per share.
Cost of Debt RD	7.20%
Tax Rate	35.00%
Debt's Weight WD	30.00%
Equity's Weight (1-30%) WE	70.00%
Cost of equity RE = Rf + Beta x MRP ; 4%+1.55 x 7%	14.85%
WACC = WE x RE + WD x RD x(1-Tax)
WACC = 70% x 14.85% + 30% x 7.2% x (1-35%)	11.80%
Value of Operation = FCF x (1+ g)/WACC -g
Value of Operation = $2,000,000 x (1+5%)/(11.80% - 5%)	$30.89	millions
Debt (Given)	$11.54	millions
Value of equity = Value of Operation - Value of Debt;($30.89 - $11.54)	$19.35	millions
Shares Outstanding	1	millions
Price = $19.35 million / 1 million shares	$19.35	per share
Part B
	In millions
FCF1	2.3
FCF2	3.2
FCF3	3.4
FCF4	4
Growth Rate	5.00%
WACC (calculated above)	11.80%
Horizon Value = FCF4 x (1+g)/WACC -g)
Horizon Value = 4 x (1+5%)/(11.80% -5%)	$61.77	Millions
Debt Interest	1.50
Debt Interest tax Shield = $1,500,000 x 35%	0.53
Horizon value of Interest tax shield= Debt interest 4yr x(1+g)/WACC-g)
Horizon value of Interest tax shield = ($1.476x 35% x (1+5%))/(11.80%-5%)	$7.98	millions
Year	FCF	Tax Shield	FCF + Tax shield	PV @ 11.80%	Present Value
1	2.3	0.53	2.825	0.8945	$2.53	Millions
2	3.2	0.53	3.725	0.8000	$2.98	Millions
3	3.4	0.53	3.925	0.7156	$2.81	Millions
4	4	0.5166	4.5166	0.6401	$2.89	Millions
Horizon Value	61.77379026	7.978085013	69.75187528	0.6401	$44.65	Millions
				Value of Operations	$55.85	Millions
Value of equity = Value of Operation - Value of Debt;($55.85 - $11.54)	$44.31	millions
Shares Outstanding	1	Millions
Price = $44.31million / 1 million shares	$44.31	per share
The bid for each share should range between $19.35 and $44.31