Happy Times, Inc., wants to expand its party stores into the Southeast. In order

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 $200 million and a YTM of 7 percent. The company's market capitalization is $320 million, and the required return on equity is 12 percent. Joe's currently has debt outstanding with a market value of $28.5 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 1.9 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 EVEBITDA multiple. The appropriate EVIEBITDA 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 $

Explanation / Answer

a. WACC calculation for Happy Times:
weight of debt = 200,000,000/(200,000,000+320,000,000) = 38.46%

weight of equity = 1=38.46% = 61.54%

Thus WACC = 0.3846*7%*(1-30%) + 0.6154*12%

= 9.27%

Now we will have to compute cash flows for each year:

After 5 years the perpetual growth rate is 4%. Thus terminal value is:

TV 5 = CF6/(WACC-g) = 10,666,233.45*1.04/(0.0927-0.04) = $210,521,863.06

Thus present value = 7840000/1.0927^1 + 8467200/1.0927^2 + 9144576/1.0927^3 + 9876142.08/1.0927^4+10666233.45/1.0927^5+210521863.06/1.0927^5

= $170,198,327.56

Market value of equity = market value of company - market value of debt

= 170,198,327.56 - 28,500,000

= $141,698,327.56

Share price = 141,698,327.56/1,900,000 shares

= $74.58

b. EBITDA = ebit+depreciation = 19,046,845.44+1,142,810.73 = $20,189,656.17 (for year 5)

TV5 = EBITDA*10 = 20,189,656.17*10 = $201,896,561.66

V0 = 7840000/1.0927^1 + 8467200/1.0927^2 + 9144576/1.0927^3 + 9876142.08/1.0927^4+201,896,561.66/1.0927^5

= $157,813,859.63

Market value of equity = market value of company - market value of debt

= 157,813,859.63 - 28,500,000

= $129,313,859.63

Share price = $129,313,859.63/1,900,000

= $68.06

Year 1 Year 2 Year 3 Year 4 Year 5 EBIT 14,000,000.00 15,120,000.00 16,329,600.00 17,635,968.00 19,046,845.44 8% annual growth less: Taxes (at 30%) 4,200,000.00 4,536,000.00 4,898,880.00 5,290,790.40 5,714,053.63 Net income 9,800,000.00 10,584,000.00 11,430,720.00 12,345,177.60 13,332,791.81 Add: Depreciation (6% of EBIT) 840,000.00 907,200.00 979,776.00 1,058,158.08 1,142,810.73 OCF 10,640,000.00 11,491,200.00 12,410,496.00 13,403,335.68 14,475,602.53 less: Capital sepnding (13% of EBIT) 1,820,000.00 1,965,600.00 2,122,848.00 2,292,675.84 2,476,089.91 less: change in NWC (7% of EBIT) 980,000.00 1,058,400.00 1,143,072.00 1,234,517.76 1,333,279.18 Cash flow from assets 7,840,000.00 8,467,200.00 9,144,576.00 9,876,142.08 10,666,233.45

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