Question

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 1.45 (given its target capital structure). Vandell has $8.75 million in debt that trades at par and pays an 7.7% 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. Vandell pays a 40% combined federal and state tax rate. The risk-free rate of interest is 5% and the market risk premium is 6%. Hastings’ first step is to estimate the current intrinsic value of Vandell.

1. What are Vandell’s cost of equity and weighted average cost of capital? Round your answer to two decimal places. Do not round intermediate calculations.
   Cost of equity:  %
   WACC:  %

2. What is Vandell's intrinsic value of operations? (Hint: Use the free cash flow corporate valuation model.) Round your answer to two decimal places. Do not round intermediate calculations.
   $    million

3. What is the current intrinsic value of Vandell's stock? Round your answer to the nearest cent. Do not round intermediate calculations.
   $   /share

Answer 1

Solution:
a.	Cost of equity	13.70	%
	WACC	10.98	%
Working Notes:
	Using CAPM
	Cost of equity
	= risk-free rate + risk premium x Beta
	Risk free rate rf = 5%
	Market risk premium = 6%
	Beta = 1.45
	Cost of equity
	= risk-free rate + risk premium x Beta
	= 5% + 6% x 1.45
	= 5% + 8.7%
	= 13.70%
	WACC
	E/V = Equity weight in capital structure = (1-0.30) = 0.70
	D/V = Debt weight in capital structure =30% = 0.30
	Ke = cost of equity = 13.70%
	Kd = cost of debt = 7.7%
	tax rate = 40%
	WACC = (E/V x Ke) + (D/V x Kd x (1-tax rate))
	WACC = (0.70 x 13.70% ) + (0.30 x 7.7% x (1- 0.40))
	WACC = 9.59% + 1.386%
	WACC = 10.976%
	WACC = 10.98%
b.	Vandell's intrinsic value of operations	$35.14	million
Working Notes:
	Vandell's intrinsic value of operations
	=FCF0 x (1+g) / (WACC-g)
	FCF0 = $2 million
	g=5%
	WACC = 10.976%
	Vandell's intrinsic value of operations
	=FCF0 x (1+g) / (WACC-g)
	= $2 million x ( 1+ 0.05)/(0.10976 - 0.05)
	=$35.14056225 million
	=$35.14 million
c.	Current intrinsic value of Vandell's stock	$26.39
Working Notes:
	Current intrinsic value of Vandell's stock
	=Value of firm/no of share outstanding
	Value of firm =Vandell's intrinsic value of operations - Value of debt
	Value of firm =$35.14056225 million - $8.75 million
	Value of firm =$26.39056225 million
	Current intrinsic value of Vandell's stock
	=$26.39056225 million /1 million shares
	=$26.39056225
	=$26.39
Please feel free to ask if anything about above solution in comment section of the question.