Problem 22-1 Valuation Hastings Corporation is interested in acquiring Vandell C

Question

Problem 22-1
Valuation

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt. Vandell's debt interest rate is 8%. Assume that the risk-free rate of interest is 7% and the market risk premium is 5%. Both Vandell and Hastings face a 40% tax rate.

Vandell's free cash flow (FCF0) is $1 million per year and is expected to grow at a constant rate of 4% a year; its beta is 1.35. What is the value of Vandell's operations? (Hint: Use the corporate valuation model.) Round your answer to two decimal places. Do not round intermediate calculations.
$   _____ million

If Vandell has $9.40 million in debt, what is the current value of Vandell's stock? (Hint: Use the corporate valuation model.) Round your answer to the nearest cent. Do not round intermediate calculations.
$ _____/share

Explanation / Answer

Solution:

1) Calculation of the value of Vandell's operations:

FCF0 = 1 million; g = 4%; b = 1.35; rRF = 7%; RPM = 5%; wd = 30%; T = 40%; rd = 8%

FCF1 = 1.00 (1.04) = 1.04 million

Cost of equity = Risk Free Rate + Beta Coefficient * Market Risk Premium

= 7% + 1.35 * 5%

= 7% + 6.75%

= 13.75%

WACC = wdrd (1-T) + wsrs

= 30% * 8% * (1-40%) + 70% * 13.75%

= 11.07%

Vops = FCF0 * (1+g) / (WACC-g)

= 1 (1+0.04) / (11.07% - 4%)

= 1.04 / 7.07

= 14.71 million

2) Calculation of the current value of Vandell's stock:

VS = Vops – Debt

= 14.71 – 9.40

= 5.31 million

Price = 5.31 / 1 million shares

= 5.31 per share

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