Question

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 $120 million and a YTM of 6 percent. The company’s market capitalization is $340 million, and the required return on equity is 11 percent. Joe’s currently has debt outstanding with a market value of $29.5 million. The EBIT for Joe’s next year is projected to be $13 million. EBIT is expected to grow at 10 percent per year for the next five years before slowing to 3 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 9 percent, 15 percent, and 8 percent, respectively. Joe’s has 2.25 million shares outstanding and the tax rate for both companies is 38 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.)

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 8.

b. 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.)

Please show work for both parts (a & b)

Answer 1

FCF %	46.00%
wd	26.09%
we	73.91%
WACC	9.10%

Free Cash Flow (FCF) = EBIT x (1 - tax) + Depreciation - Capital Spending - Net working capital

= EBIT x (1 - 38% + 8% - 15% - 9%) = 46% x EBIT

wd - weight of debt = 120 / (120 + 340) = 26.09% and we - weight of equity = 1 - 26.09% = 73.91%

=> WACC = 26.09% x 6% x (1 - 38%) + 73.91% x 11% = 9.10%

Happy Times	1	2	3	4	5	6
EBIT	$          13.00	$      14.30	$     15.73	$ 17.30	$           19.03	$   19.60
FCF	$             5.98	$        6.58	$       7.24	$   7.96	$             8.76	$      9.02
TV					$        147.81
EV	$123.49
Equity Value	$93.99
Share Price	$41.77

Forecast EBIT given the growth rate and subsequent FCF

Terminal Value (TV) = FCF 6 / (WACC - g) = 9.02 / (9.10% - 3%) = $147.81

EV = FCF1 / (1 + WACC) + FCF2 / (1 + WACC)^2 + ... + (FCF5 + TV) / (1 + WACC)^5

= $123.49

Equity Value = EV - Debt = 123.49 - 29.5 = 93.99

Share Price = 93.99 / 2.25 = $41.77

b) If TV = EBIT x (1 + depreciation) x multiple = 19.03 x (1 + 8%) x 8 = $164.45 in a

Share Price = $46.55