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 $220 million and a YTM of 9 percent. The company’s market capitalization is $300 million, and the required return on equity is 14 percent. Joe’s currently has debt outstanding with a market value of $27.5 million. The EBIT for Joe’s next year is projected to be $16 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 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?

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?

Answer 1

Cost % 14.00% Market WACC (Cost value Weights %*Weights) $ 300 0.58 8.08% Common stock Debt (After tax cost) $ 220 0.42 2.36% 5.58% =9%*(1-38%) Total | $ 520 1.00 WACC 10.44%

Depreci in wel Depreci Increase Capital Year EBIT Tax EBIT-Taxation in NWC spending | FCF 1 $16.00 $6.08 $ 9.92 $ 1.28 $ 1.44 $ 2.40 $ 7.36 2 $17.60 $6.69 $ 10.91 $ 1.41 $ 1.58 $ 2.64 $ 8.10 3 $19.36 $7.36 $ 12.00 $ 1.55 $ 1.74 $ 2.90 $ 8.91 4 $21.30 $8.09 $ 13.20 $ 1.70 $ 1.92 $ 3.19 $ 9.80 5 $23.43 $8.90 $ 14.52 $ 1.87 $ 2.11 | $ 3.51 | $10.78 Free cash flows 1 $ 7.36 Free cash flows 2 $ 8.10 Free cash flows 3 $ 8.91 Free cash flows 4 $ 9.80 Free cash flows 5 $ 10.78 Firm value at year 5 $ 149.23 10.78*(1+3%)/(10.44%-3%) Firm value Less: Debt PVIF @ 10.44% Present value 0.905 $ 6.66 0.820 $ 6.64 0.742 $ 6.61 0.672 $ 6.59 0.609 $ 6.56 0.609 $ 90.84 | $ $ 123.90 27.50 Equity value 96.40 Number of shares 2.00 a) Maximum share price $ 48.20

Year EBIT 1 $ 16.00 2 $17.60 3 $ 19.36 41 $21.30 5 $23.43 Tax $6.08 $6.69 $7.36 $8.09 $8.90 EBIT-Tax $ 9.92 $ 10.91 $ 12.00 $ 13.20 $ 14.52 Depreci Increase Capital ation in NWC spending FCF $ 1.28 $ 1.44 $ 2.40 $ 7.36 $ 1.41 $ 1.58 $ 2.64 $ 8.10 $ 1.55 $ 1.74 $ 2.90 $ 8.91 $ 1.70 $ 1.92 $ 3.19 $ 9.80 $ 1.87 $ 2.11 $ 3.51 $ 10.78 Free cash flows 1 Free cash flows 2 Free cash flows 3 Free cash flows 4 Firm value at year 5 $ $ $ $ $ 7.36 8.10 8.91 9.80 202.40 PVIF @ 10.44% | Present value 0.905 $ 6.66 0.820 $ 6.64 0.742 $ 6.61 0.672 $ 6.59 0.609 $ 123.20 $ Firm value Less: Debt 149.70 27.50 S Equity value 1 $ 122.20 Number of shares 2.00 b) Maximum share price $ 61.10

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