The following information is available about Russell Brewing Company. Stock pric

Question

The following information is available about Russell Brewing Company. Stock price is $ 8 per share, common shares outstanding is 10 million, Market value of interest-bearing debt is 75 million, and Weighted average cost of capital is 14 %.

A private-equity company is confident that by terminating Russell's money losing fruit-flavored beer coolers and by selling the women's hosiery division free cash flow can be increased $4 million annually for the next decade. In addition, they estimate that an immediate, special dividend of $10 million can be financed by the sale of the hosiery division.

QUESTION:

a. Assuming these actions do not affect Russell's cost of capital, what is the maximum price per share the investment company would be justified in bidding for control of Russell? What percentage premium does this represent?

b. Conduct a sensitivity analysis of your answer to (a) by assuming the cost of capital is 15 percent and the increased cash flow is only $3.5 million per year.

Explanation / Answer

Part A)

The maximum justifiable premium is difference between the fair market value of the Russell under new management and value of debt under existing management.

We will require the fair market value of the firm under existing management which will be calculated with the use of market value of equity and market value of debt. The formula for calculating fair market value under existing management can be derived as follows:

Fair market value under Existing Management = Current Value of Debt + Current Value of Equity

The fair market value under new management will comprise of fair market value under existing management and present value of annual cash flows and amount realized from sale of division. The formula for calculating fair market value under new management can be derived as follows:

Fair market value under New Management = Fair market value under Existing Management + Present Value of Annual Cash Flows for an Annuity for 10 Years at 14% + Sales Value

Present Value of Cash Flows = Annual Cash Flow*PVIFA(%,n) where % is discount rate (WACC), n is years and PVIFA is the present value interest factor for an annuity (it can be derived from present value of an annuity table or a financial calculator)

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Using the information provided in the question we get

Here, Cash Flow will be 4million per year and cost of capital will be 14%. So, we will have to take the present interest factor for these values which would be 5.026.

Fair market value under Existing Management = 8*10 + 75 = $155 million

Fair market value under New Management = 155 + 4*5.216 + 10 = $185.86

Fair Market Value of Equity = $185.86 - $75 = $110.86

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Fair Market Value of Equity Per Share (Maximum Price Per Share) = Fair Market Value of Equity/Common Stock Outstanding = $110.86/10 = $11.09

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Percent Premium = (Maximum Price Per Share - Current Price)/Maximum Price Per Share*100 = (11.09 - 8)/8*100 = 38.63%

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Part B)

We will have to calculate the revised value of equity per share with the same approach as used in Part A).

____________________

Here, Cash Flow will be 3.5 million per year and cost of capital will be 15%. So, we will have to take the present interest factor for these values which would be 5.019

Fair market value under New Management = 155 + 4*5.019 + 10 = $182.57 million

Fair Market Value of Equity = $182.57 - $75 = $107.57

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Fair Market Value of Equity Per Share (Maximum Price Per Share) = Fair Market Value of Equity/Common Stock Outstanding = $107.57/10 = $10.76

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Percent Premium = (Maximum Price Per Share - Current Price)/Maximum Price Per Share*100 = (10.76 - 8)/8*100 = 34.5%

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