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 1.20 (given its target capital structure). Vandell has $11.48 million in debt that trades at par and pays an 7.4% interest rate. Vandell’s free cash flow (FCF₀) is $2 million per year and is expected to grow at a constant rate of 6% a year. Both Vandell and Hastings pay a 35% combined federal and state tax rate. The risk-free rate of interest is 5% and the market risk premium is 8%.

Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.3 million, $2.9 million, $3.3 million, and $3.71 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 6% rate. Hastings plans to assume Vandell’s $11.48 million in debt (which has an 7.4% 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 $1.425 million, after which the interest and the tax shield will grow at 6%.

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

Step 1: Calculate Vandell's Cost of Equity And WACC Under Current Scenario

The Vandell's cost of equity and WACC under current scenario is arrived as below:

Cost of Equity = Risk Free Rate + Beta*Market Risk Premium = 5% + 1.2*8% = 14.60%

WACC = Weight of Debt*Cost of Debt*(1-Tax Rate) + Weight of Equity*Cost of Equity = 30%*7.4%*(1-35%) + (1-30%)*14.60% = 11.66%

_____

Step 2: Calculate Vandell's Total Intrinsic Value and Current Intrinsic Value of Vandell's Stock Under Current Scenario

The value of Vandell's total intrinsic value and current intrinsic value of Vandell's stock is determined as follows:

Total Intrinsic Value = Free Cash Flow Per Year*(1+Growth Rate)/(WACC - Growth Rate) = 2*(1+6%)/(11.66% - 6%) = $37.44 million

Current Intrinsic Value of Vandell's Stock = (Total Intrinsic Value - Value of Debt)/Number of Outstanding Shares = (37.44 - 11.48)/1 = $25.96

_____

Step 3: Calculate Pre-acquisition Levered Cost of Equity

The value of pre-acquisition levered cost of equity is arrived as follows:

Pre-acquisition Levered Cost of Equity = Weight of Debt*Cost of Debt + Weight of Equity*Cost of Equity = 30%*7.4% + 70%*14.60% = 12.44%

_____

Step 4: Calculate Total Present Value of Tax Shields

The total present value of tax shields is calculated as below:

Tax Shield (for Year 1 to Year 3) = Annual Interest Amount*Tax Rate = 1.5*35% = $0.525

Tax Shield for Year 4 = Interest Amount for Year 4*Tax Rate = 1.425*35% = 0.49875

Total Present Value of Tax Shields = Tax Shield Year 1/(1+Pre-acquisition Levered Cost of Equity)^1 + Tax Shield Year 2/(1+Pre-acquisition Levered Cost of Equity)^2 + Tax Shield Year 3/(1+Pre-acquisition Levered Cost of Equity)^3 +  Tax Shield Year 4/(1+Pre-acquisition Levered Cost of Equity)^4 + Tax Shield Year 4*(1+Growth Rate)/(Pre-acquisition Levered Cost of Equity-Growth Rate)*1/(1+Pre-acquisition Levered Cost of Equity) = .525/(1+12.44%)^1 + .525/(1+12.44%)^2 + .525/(1+12.44%)^3 + .49875/(1+12.44%)^4 + .49875*(1+6%)/(12.44%-6%)*1/(1+12.44%)^4 = $6.70 million

_____

Step 5: Calculate Value of Vandell Operations

The value of Vandell operations is calculated as follows:

Unlevered Value of Operations = Cash Flow Year 1/(1+Pre-acquisition Levered Cost of Equity)^1 + Cash Flow Year 2/(1+Pre-acquisition Levered Cost of Equity)^2 + Cash Flow Year 3/(1+Pre-acquisition Levered Cost of Equity)^3 + Cash Flow Year 4/(1+Pre-acquisition Levered Cost of Equity)^4 + Cash Flow Year 4*(1+Growth Rate)/(Pre-acquisition Levered Cost of Equity - Growth Rate)*1/(1+Pre-acquisition Levered Cost of Equity)^4 = 2.3/(1+12.44%)^1 + 2.9/(1+12.44%)^2 + 3.3/(1+12.44%)^3 + 3.71/(1+12.44%)^4 + 3.71*(1+6%)/(12.44% - 6%)*1/(1+12.44%)^4 = $47.19 million

Value of Vandell Operations = Unlevered Value of Operations + Total Present Value of Tax Shields = 47.19 + 6.70 = $53.89 million

_____

Step 6: Calculate Per Share Value to Hastings

The per share value to Hastings is arrived as below:

Per Share Value to Hastings = (Value of Vandell Operations - Value of Debt)/Number of Outstanding Shares = (53.89 - 11.48)/1 = $42.41

_____

Step 7: Determine Price Range

The bid for each share should range between $25.96 per share and $42.41 per share: