Question

It was right at the beginning of 2019. Myron Bronco Incorporation (MB) was a medium-sized company listed in a share market. Largely owned by a traditional and financially conversative elite family, the company operated in a lower-risk and mildly-competitive industry. With thin trading of its shares in the stock exchange, the family has been considerably successful in controlling major decisions/directions made by the company. The family-owners of the company also take pride with the fact the business has managed to stay constantly debt-free (long-term debt) for more than a decade or so.

In the same share market, there was an active group of hedge funds that seek for companies that can be easily turned around to create additional value. Circling Vulture Fund (CVF) was one of them. Surely and slowly enough, CVF has recently set its eyes on MB.

At the beginning of 2019, Genghis Smith, the managing partner of CVF projected the future (debt-free) free cash flows of MB as follows:

After 2025, yearly FCFs are projected to be perpetual and stay at 32.4 million $.

The Beta of MB from regression estimation (based on the past three-year daily data) is 0.75. The relevant risk-free rate and the market risk premium were 5% and 2% respectively. The treasury department of MB estimates the cost of debt if the company is to borrow to be 5.5% per year.

As observed in the beginning of 2019, share price of MB was 150 while EPS was 30. The number of shares outstanding was 5 million shares. The P/E ratio of the slow-growth industry MB belongs to was only 3.

The corporate tax rate is 21%.

1. Ignore additional perspectives of the proposal on signalling effects, voting rights, difficulties to take over corporate control, and others. If the costs involving in the process of the takeover deal (e.g. transaction costs) are estimated as 5 mil $, what is the maximum price CVF should offer to buy MB Incorporation? Do you think Genghis Smith should/could pursue this proposal?

Answer 1

0.75 32.4 5% 2% 5.50% Available Data Beta of MB from Regression estimation FCF (After 2025 in Million) Risk-free rate of return Market risk premium Cost of Debt In the beginning of 2019 Share price of MB EPS Number of shares outstanding (in Million) P/E ratio Corporate Tax rate Cost of takove deal (in Million) 150 30 5 3 21% 5 Earning of MB Total Earning of MB before tax = (EPS*No of shares)/(100-Tax Rate) Earning = (30*5)/(100-21)% Earning 2019 = 189.873418 Calculation of Share price of MB PE Ratio = Share Price/EPS Share Price = EPS*PE Ratio Share Price = 30*3 Share Price = 90 Calculation of Required rate of return Required rate of return = Risk Free Rate + Beta (Market rate of return - Risk free Rate) Required rate of return = 5 +0.75*(7-5) Required rate of return = 6.50%

Question:Maximum price CVF should offer? Calculation of Value of MB Present value = Expected Return/Required rate of return Present value after 2025 = 32.4/0.065 Present value after 2025 = 498.4615 Value of MB at the beginning of 2019 Expected Present Value Present Year Cash Inflow Factor (r=6.5%) Value 2019 189.87 0.9390 178.2849 2020 202.22 0.8817| 178.2849 2021 215.36 0.8278 178.2849 2022 229.36 0.7773 178.2849 2023 244.27 0.7299 178.2849 2024 260.14 0.68531 178.2849 2025 277.05 0.6435) 178.2849 Value of MB after 2025 498.46 0.6435| 320.7631 Total Value of MB at the beginning of 2019 1568.757 1568.76 Value CVF can offer to MB Value of MB Less: Cost of takove deal Net Amount 5 1563.76 in Million $