Question

I need help on this question. Below is the case study. Thank you:  What is the most that Pampa should pay for CCC? Why?

Pampa RV, Inc., a publicly traded firm, is considering the acquisition of Chico Clothing Company (CCC)for a price of $12 per share. CCC is a private company that specializes in manufacturing clothing, shoes and accessories for beauty pageant contestants. The RV business is slow, and Pampa's CFO believes that the acquisition of CCC will help to improve overall profitability and provide much needed cash flow. Pampa's has 500,000 shares of common stock outstanding, currently trading at $9.75 per share. The book value of the common stock is $5 per share. Pampa also has bonds with a market value of $3,500,000 and a yield to maturity of 3.4%. Based on current market valuations, Pampa is currently achieving its target debt to equity ratio. Pampa's equity beta is 0.80. CCC is a private firm that was founded ten years ago by four sisters, who have a combined 100 years of experience in the beauty pageant business as competitors, judges, and coaches. CCC's cost of goods sold (COGS) is expected to be 38% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 12% of revenues. These estimates are in line with the firm's historical performance, which is expected to continue for the foreseeable future. The firm is 100% equity financed and has 100,000 shares of common stock outstanding. Its equity beta is estimated to be 1.353. CCC has experienced rapid growth over the last ten years. However, your analysis of industry structure suggests that competition in the beauty pageant clothing and accessories market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows after five years will be a modest 1.5% per year. Your team has been hired as consultants to Pampa RV to evaluate the proposed acquisition of CCC. Tables 1 and 2 below contain additional data that you have collected during your research. The corporate tax rate is 40% for all firms.

Answer 1

The most Pampa should pay for CCC = firm value of CCC / shares outstanding of CCC

firm value = present value of next 5 years FCF + present value of terminal value at end of year 5

FCF each year = net income + depreciation - investment in Capex and NWC

terminal value at end of year 5 = Year 5 FCF * (1 + perpetual growth rate) / (cost of capital - perpetual growth rate)

Cost of capital

cost of equity = risk free rate + (beta * (expected market return - risk free rate))

cost of equity = 2.5% + (0.8 * (7.5% - 2.5%)) = 6.5%

cost of debt = YTM * (1 - tax rate) = 3.4% * (1 - 40%) = 2.04%

market value of debt = $3,500,000

market value of equity = shares outstanding * price per share = 500,000 * $9.75 = $4,875,000

total market value = $3,500,000 + $4,875,000 = $8,375,000

weight of debt = $3,500,000 / $8,375,000

weight of equity = $4,875,000 / $8,375,000

cost of capital = (weight of debt * cost of debt) + (weight of equity * cost of equity)

cost of capital = (($3,500,000 / $8,375,000) * 2.04%) + (($4,875,000 / $8,375,000) * 6.5%)

cost of capital = 5.19%

Price per share of CCC = $32.17. This is the most Pampa should pay.

А E F 1 0 1 4 5 FCF $300,000 $114,000 $15,000 $36,000 $135,000 $54,000 $81,000 $15,000 $18,000 $78,000 $335,000 $127,300 $30,000 $40,200 $137,500 $55,000 $82,500 $30,000 $25,000 $87,500 $375,000 $142,500 $40,000 $45,000 $147,500 $59,000 $88,500 $40,000 $40,000 $88,500 $410,000 $155,800 $52,000 $49,200 $153,000 $61,200 $91,800 $52,000 $50,000 $93,800 $575,000 $218,500 $60,000 $69,000 $227,500 $91,000 $136,500 $60,000 $65,000 $131,500 3 Revenues 4 COGS 5Depreciation - SGA expenses 6 7 Earnings before tax 8Taxes 9 Net Income 10Depreciation 11 - Investment in Capex and NWC 12 FCF 13 14 Terminal Value $3,617,141 15 Terminal Value 16 17 Present Value $74,152 $79,079 $76,036 $76,613 $102,107 $2,808,621 18 PV of FCF 19 PV of Terminal Value 20 21 Share Price 22 Firm Value $3,216,607 23 Shares outstanding 100,000 24 Price per share 32.17

А В C D E G 0 1 4 5 1 2 FCF 3 Revenues 300000 335000 375000 410000 575000 -D3 38 % -E3 38 % =F3 38 % - COGS -G3 38 % 4 -С3*38% 15000 Depreciation - SGA expenses 30000 40000 52000 60000 =F3 12 % 6 3С3*12% D3 12 % -E3 12 % -G3 12 % 7 Earnings before tax - Taxes -С3-С4-C5-С6 -D3-D4-D5-D6 3Е3-E4-E5-Е6 -F3-F4-F5-F6 -G3-G4-G5- G6 -G7 40 % -F7 40 % -с7-40% D7 40% -E7 40% 9 Net Income C7-C8 =D7-D8 -E7-E8 F7-F8 -G7-G8 10Depreciation %3С5 -D5 -E5 -F5 -G5 11 -Investment in Capex and NWC 18000 25000 40000 50000 65000 =D9 + D10 - D11 12 FCF -C9+C10-C11 =E9+E10- E11 =F9+F10-F11 -G9+G10-G11 13 14 Terminal Value -G12 ( 1+1.5 % ) / (5.19%-1.5 %) 15 Terminal Value 16 17 Present Value 18 PV of FCF 19 PV of Terminal Value C12/(1+5.19 %)^cı G12/(1+5.19% )^G1 -G15 / ( 1+5.19 %)^G1 -D12/ ( 1+5.19 % )^D1 F12/(1+5.19%)^F1 =E12/(1+5.19 %)^ E1 20 21 Share Price 22 Firm Value 23 Shares outstanding -SUM(C18:G18)+G19 100000 G22/G23 24 Price per share