Question

Problem 22-03

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 $10.10 million in debt that trades at par and pays an 7.2% interest rate. Vandell's free cash flow (FCF) is $2 million per year and is expected to grow at a constant rate of 4% a year. Both Vandell and Hastings pay a 30% combined federal and state tax rate. The risk-free rate of interest is 3% and the market risk premium is 5%. Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell's free cash flows to be $2.5 million, $2.7 million, $3.5 million, and $3.57 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 $10.10 million in debt (which has an 7.2% 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 $1.449 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. 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

Part A
FCF0	1	millions
Growth Rate (g)	4.00%
Risk Free Rate (Rf)	3.00%
Market Risk Premium MRP	5.00%
Beta	1.2
Cost of Debt  RD	7.20%
Tax Rate	30.00%
Debt's Weight WD	30.00%
Equity's Weight (1-30%) WE	70.00%
Cost of equity RE = Rf + Beta x MRP ; 3%+1.20x 5%	9.00%
WACC = WE x RE + WD x RD x(1-Tax)
WACC = 70% x 9.00%  +  30% x 7.2% x (1-30%)	7.81%
Value of Operation = FCF x (1+ g)/WACC -g
Value of Operation = $1,000,000 x (1+4%)/(7.81% - 4%)	$            27.28	millions
Debt (Given)	$            10.10	millions
Value of equity = Value of Operation - Value of Debt;($27.28  - $10.1)	$            17.18	millions
Shares Outstanding	1	millions
Price = $17.18 million / 1 million shares	$            17.18	per share
Part B
	In millions
FCF1	2.5
FCF2	2.7
FCF3	3.5
FCF4	3.57
Growth Rate	4.00%
WACC (calculated above)	7.81%
Horizon Value = FCF3 x (1+g)/WACC -g)
Horizon Value = $3.57 x (1+4%)/(7.81% - 4%)	$            97.40	Millions
Debt Interest	$1,500,000.00
Debt Interest  tax Shield = $1,500,000 x 30%	$   450,000.00
Horizon value of Interest tax shield= Debt interest 4yr x(1+g)/WACC-g)
Horizon value of Interest tax shield = ($1.449 x 30% x (1+4%))/(7.81%-4%)	$            11.86	millions
Year	FCF	Tax Shield	FCF + Tax shield	PV @ 7.81%	Present Value
1	2.5	0.45	2.95	0.9992	$          2.95	Millions
2	2.7	0.45	3.15	0.9984	$          3.15	Millions
3	3.5	0.45	3.95	0.9977	$          3.94	Millions
4	3.57	0.4347	4.0047	0.9969	$          3.99	Millions
Horizon Value	97.3976915	11.8596013	109.257293	0.9969	$      108.92	Millions
				Value of Operations	122.9423	Millions
Value of equity = Value of Operation - Value of Debt;($122.94 - $10.10)	$          112.84	millions
Shares Outstanding	1	Millions
Price = $112.84million / 1 million shares	$          112.84	per share
The bid for each share should range between $17.81 and $112.84