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 $160 million and a YTM of 7 percent. The company’s market capitalization is $400 million, and the required return on equity is 12 percent. Joe’s currently has debt outstanding with a market value of $31.5 million. The EBIT for Joe’s next year is projected to be $14 million. EBIT is expected to grow at 8 percent per year for the next five years before slowing to 4 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 7 percent, 13 percent, and 6 percent, respectively. Joe’s has 1.95 million shares outstanding and the tax rate for both companies is 30 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.)

Maximum share price            $

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 10.

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.)

Maximum share price            $

Answer 1

Part a)

Step 1: Calculate Weighted Average Cost of Capital

The Weighted Average Cost of Capital can be calculated with the use of following formula:

WACC = Weight of Debt*After-tax Cost of Debt*Cost of Equity

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Using the values provided in the question, we get,

Weight of Debt = Market Value of Debt/(Market Value of Debt+Market Value of Equity) = 160,000,000/(160,000,000+400,000,000)

Weight of Equity = Market Value of Equity/(Market Value of Debt+Market Value of Equity) = 400,000,000/(160,000,000+400,000,000)

After-tax Cost of Debt = YTM*(1-Tax Rate) = 7%(1-30%) = 4.90%

Cost of Equity = 12%

Now, we can get WACC as follows:

WACC = 160,000,000/(160,000,000+400,000,000)*4.90% + 400,000,000/(160,000,000+400,000,000)*12% = 9.97%

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Step 2: Calculate Cash Flows from Assets

The cash flows are calculated with the use of following table:

Cash Flow from Assets
	Year 1	Year 2	Year 3	Year 4	Year 5
EBIT	14,000,000	15,120,000	16,329,600	17,635,968	19,046,845
Less: Taxes	4,200,000	4,536,000	4,898,880	5,290,790	5,714,054
Net Income	9,800,000	10,584,000	11,430,720	12,345,178	13,332,792
Add: Depreciation (6%*EBIT)	840,000	907,200	979,776	1,058,158	1,142,811
Operating Cash Flows	10,640,000	11,491,200	12,410,496	13,403,336	14,475,603
Less: Capital Spending (13%*EBIT)	1,820,000	1,965,600	2,122,848	2,292,676	2,476,090
Change in Working Capital (7%*EBIT)	980,000	1,058,400	1,143,072	1,234,518	1,333,279
Cash Flow from Assets	$7,840,000	$8,467,200	$9,144,576	$9,876,142	$10,666,233

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Step 3: Calculate Terminal Value of the Cash Flow

The terminal value of the cash flow is calculated as below:

Terminal Value = Cash Flow from Assets Year 5*(1+Growth Rate)/(WACC-Growth Rate) = 10,666,233*(1+4%)/(9.97%-4%) = $185,810,424.12

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Step 4: Calculate Share Price

To calculate the share price, we need to calculate the present value/market value of cash flows/firm as follows:

Present Value of Cash Flows = Cash Flow from Assets Year 1/(1+WACC)^1 + Cash Flow from Assets Year 2/(1+WACC)^2 + Cash Flow from Assets Year 3/(1+WACC)^3 + Cash Flow from Assets Year 4/(1+WACC)^4 + (Cash Flow from Assets + Terminal Value from Year 5)/(1+WACC)^5 = 7,840,000/(1+9.97%)^1 + 8,467,200/(1+9.97%)^2 + 9,144,576/(1+9.97%)^3 + 9,876,142/(1+9.97%)^4 + (10,666,233 + 185,810,424.12)/(1+9.97%)^5 = $149,922,743.81

Share Price = (Present Value of Cash Flows - Joe's Market Value of Debt)/Number of Outstanding Shares = (149,922,743.81 - 31,500,000)/1,950,000 = $60.73 per share

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Part b)

The revised terminal value is calculated as below:

Terminal Value = EBITDA*10 = (19,046,845 + 1,142,811)*10 = 20,189,656*10 = $201,896,560

Now, we can calculate the revised present value of cash flows as below:

Revised Present Value of Cash Flows = Cash Flow from Assets Year 1/(1+WACC)^1 + Cash Flow from Assets Year 2/(1+WACC)^2 + Cash Flow from Assets Year 3/(1+WACC)^3 + Cash Flow from Assets Year 4/(1+WACC)^4 + ( Terminal Value from Year 5)/(1+WACC)^5 = 7,840,000/(1+9.97%)^1 + 8,467,200/(1+9.97%)^2 + 9,144,576/(1+9.97%)^3 + 9,876,142/(1+9.97%)^4 + 201,896,560/(1+9.97%)^5 = $153,292,669.93 [cash flow from assets for Year 5 will not be considered in this case]

The new estimate of the share price is determined as below:

New Estimate of Share Price = (Revised Present Value of Cash Flows - Joe's Market Value of Debt)/Number of Outstanding Shares = (153,292,669.93 - 31,500,000)/1,950,000 = $62.46 per share

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Notes:

There can be a slight difference in final answers on account of rounding off values.