Happy Times, Inc., wants to expand its party stores into the Southeast. In order
ID: 2613557 • Letter: H
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 $240 million and a YTM of 9 percent. The company’s market capitalization is $360 million, and the required return on equity is 14 percent. Joe’s currently has debt outstanding with a market value of $35.5 million. The EBIT for Joe’s next year is projected to be $16.0 million. EBIT is expected to grow at 8 percent per year for the next five years before slowing to 4 percent in perpetuity. Increases in net working capital and capital spending as a percentage of EBIT are expected to be 7 percent and 13 percent, while depreciation is expected to be 6 percent of EBIT. Joe’s has 2.35 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 final 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 EV / EBITDA multiple. The appropriate EV / EBITDA multiple is 8.
b. What is your new estimate of the maximum share price for the purchase? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Maximum share price $
Explanation / Answer
Solution:
Step 1: Calculate Weighted Average Cost of Capital (WACC) for the acquiring firm (Happy Times). This is their expected rate of return from the acquisition
Step 2: We are required to calculate the Free Cash flow to firm (FCFF) of Joe for the next 5 years using the data given for EBIT, Working capital, Capital spending and Depreciation.
Step 1: The FCFF will be discounted using WACC of the acquiring firm (Happy Times) to calculate the present value of FCFF.
Step 3: After that we have to calculate the terminal value of Joe, which can be calculated using two methods - Perpetual growth rate method and EV/EBITDA method.
Step 4: The present value of Terminal value will be calculated by discounting it using WACC and will be added to present value of FCFF to calculate the Enterprise value of Joe.
Step 5: Fair value to shareholders of Joe will be calculated by deducting Joe's Debt from its Enterprise value
Step 6: Intrinsic value of Joe will be calculated by dividing Fair value to shareholders by number of shares outstanding.
Calculation of WACC for Happy Times
Market value of Debt = $240.0MM, YTM = 9%, Market capitalization (Equity) = $360.0MM, Required return on equity (Ke) = 14%, Tax rate = 30%
Formula to calculate WACC = (Debt*YTM*(1-tax rate) + Equity*Ke)/(Debt + Equity)
= (240*9%*(1-30%) + 360*14%)/(240+360)
= 10.9%
Hence, WACC = 10.9%
Calculation of FCFF of Joe for 5 years
Calculation of PV of FCFF
Method 1: Perpetual growth rate
Calulation of Terminal Value
Perpetual growth rate (G)= 4%
EBIT after 5 years = $21.767
Tax effected EBIT = $15.2
Terminal value formula = Tax effected EBIT *(1 + G)/(WACC-G)
= 15.2 * (1+4%)/(10.9%-4%)
= $229.0025
Adjusting for Depreciation, Capital spending and Working capital expenditure
Terminal value = $183.202
Present value of Terminal value = $183.202 * 0.595595 = $109.11412
Calculation of Enterprise value = Sum of PV of FCFF + PV of Terminal value
= 38.31819 + 109.11412 = $147.4323
Fair Value to shareholders = Enterprise value - Debt
= 147.4323 - 35.5 = 111.9323
Number of shares outstanding = 2.35
Intrinsic value of Joe = 111.9323/2.35 = $47.63
Maximum share price in this case = $47.63
Method 2: EV/EBITDA method
Calculation of EBITDA for 5th year
EBITDA = EBIT + Depreciation = 21.76+1.31 = 23.07
Calulation of Terminal Value
EV/EBITDA = 8, EBITDA = 23.07
EV = 8*23.07
= $184.5911 (or Terminal value)
Present value of Terminal value = $184.5911 * 0.595595 = $109.9415
Calculation of Enterprise value = 109.9415+ 38.31819 = $148.2597
Fair value to shareholders = 148.2597-35.5 = 112.7597
Intrinsic value = 112.7597/2.35
= $47.98
Maximum share price in this case = $47.98
Year 1 2 3 4 5 EBIT (Growth rate=8%) 16 17.280 18.662 20.155 21.768 Tax (at 30%) -4.80 -5.18 -5.60 -6.05 -6.53 Net working capital (7% of EBIT) -1.12 -1.21 -1.31 -1.41 -1.52 Capital spending (13% of EBIT) -2.08 -2.25 -2.43 -2.62 -2.83 Depreciation (6% of EBIT) 0.96 1.04 1.12 1.21 1.31 FCFF 8.96 9.68 10.45 11.29 12.19Related Questions
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