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 1.30 (given its target capital structure). Vandell has $8.27 million in debt that trades at par and pays a 7.6% interest rate. Vandell’s free cash flow (FCF0) is $1 million per year and is expected to grow at a constant rate of 4% a year. Both Vandell and Hastings pay a 35% combined federal and state tax rate. The risk-free rate of interest is 7% and the market risk premium is 6%. Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.6 million, $2.7 million, $3.5 million, and $3.85 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 4% rate. Hastings plans to assume Vandell’s $8.27 million in debt (which has a 7.6% interest rate) and raise additional debt financing at the time of the acquisition. Hastings estimates that interest payments will be $1.6 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 $1.428 million, after which the interest and the tax shield will grow at 4%. Indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition. Do not round intermediate calculations. Round your answers to the nearest cent.

The bid for each share should range between $ per share and $ 2 per share.

Answer 1

Calculation of share price of Vandell Corporation

No of shares= 1 million

Beta(Be) =1.30

Risk free rate of return(Rf) =7%

Market risk premium =6%

Return on equity(Re) = Rf+ market risk premium*Be

                                       = 7+(6)1.30

                                       14.8%

Interest rate on debt =7.6%

Post tax interest rate(Kd) =7.6(1-0.35)= 4.94%

Debt =$8.27 million( 30 % of capital structure)

Therefore Equity portion being (70%) = $19.30 million

Calculation of WACC

Capital        Amount         Weight             Cost (%)                   WACC(weight*cost)

Equity          19.30                .70                 14.8                            10.36          

Debt              8.27                 .30                  4.94                            1.48

                     27.57                                                                           11.84

Free cashflow =$ 1 million

Growth rate =4%

Value of Vendell =Free cashflow /(WACC- growth rate)

                                  1 (0.1184-0.04)

                                   $ 12.76 million

Share price = Value / No. of shares

                        12.76/ 1

Share price = $ 12.76

Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.6 million, $2.7 million, $3.5 million, and $3.85 million at Years 1 through 4

Interest payment (1-3)=$ 1.6 million

Extra interest =1.6-( 8.27*7.6)0.629= $ 0.971 million

Post tax interest(1-3) = 0.971(1-0.35) = $ 0.631 million

Extra interest of 4^th year =1.428-0.629 = $ 0.799 million

Post tax interest 0f 4^th year =$ 0.519 million

Year       Cashflow($) - Extra interest = Net cashflow        PV (11.84)         PV of Net cash flow         

1               2.6                    (0.631)                1.969                   0.894                          1.76

2               2.7                    (0.631)                2.069                   0.799                          1.65

3               3.5                   (0.631)                2.869                   0.715                          2.05

4               3.85                  (0.519)                3.331                   0.639                          2.13                        

                                                                                                        value                        7.59

After 4^th year

Free cashflow increase by 4 %=3.85*1.04= $4.004 million

Extra interest will be = 0.799*1.04= $ 0.831 million

Tax rate will be 39 %

Post tax extra interest = $ 0.51 million

Post tax free cashflow (with new tax)= $ 3.75 million

Net Cashflow = free cashflow – post tax extra interest

                          3.75-0.51 = $ 3.24 million

Value= 3.24/(0.1184-0.04)=$ 41.33 million

Share price =41.33/1

                     =$ 41.33

Therefore the range for bid will be between 12.76 – 41.33