Problem 22-3 Merger Bid Hastings Corporation is interested in acquiring Vandell

Question

Problem 22-3
Merger Bid

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 7.2%. Assume that the risk-free rate of interest is 5% and the market risk premium is 4%. Both Vandell and Hastings face a 35% tax rate.

Vandell's free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 4% a year; its beta is 1.25.

Hastings estimates that if it acquires Vandell, interest payments will be $1,500,000 per year for 3 years after which the current target capital structure of 30% debt will be maintained. Interest in the fourth year will be $1.427 million after which interest and the tax shield will grow at 4%. Synergies will cause the free cash flows to be $2.3 million, $3.1 million, $3.5 million, and then $3.69 million, after which the free cash flows will grow at a 4% rate. Assume Vandell now has $11.85 million in debt.

Indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition. Round your answers to the nearest cent. Do not round intermediate calculations.

The bid for each share should range between $____    per share and $_____    per share.

answer is not 3.5 and 6.7

Explanation / Answer

Solution:

FCF1 = 2.00(1.04) = $2.08 million; g = 4%; b = 1.25; rRF = 5%; RPM = 4%; wd = 30%; T = 35%; rd = 7.2%

rs        = rRF + RPM(b)

           = 5% + 4%(1.25)

           = 10%.

WACC = wdrd(1-T) + wsrs

           = 0.30(7.2%)(0.65) + 0.70(10%)

           = 7.014%

Vops     = FCF0 (1 + g)/ (WACC – g)

           = $2.08/ (0.07014 – 0.04)

           = $29.82 million

VS      = Vops – debt

           = 29.82 – 11.85 = $17.97 million

     Price          = 17.97million / 1 million shares

                       = $17.97 / share.

Horizon Value3                 = FCF3(1+g)/(WACC – g)

                                          = 3.5 (1.04)/(.07014 – 0.04)

                                          = $120.77 million

Tax shields in years 1 through 3 are:

            TS1 = TS2 = TS3    = Interest x T

                                          = 1,500,000 x 0.35

                                          = 525,000

FCF + Tax Shield + Horizon Value =

            Year 1: 2.3 million + 525,000 = 2.825 million

            Year 2: 3.1 million + 525,000 = 3.625 million

            Year 3: 3.5 million + 525,000 + 120.77 million = 124.8 million

The unlevered cost of equity based on the pre-merger required rate of return and pre-merger capital structure is:

            rsU     = wdrd + wsrsL

                    = 0.30(7.2%) + 0.70(10%)

                    = 9.16%

The present value of the FCFs, the tax shields, and the horizon value at the unlevered cost of equity is:

            Vops   = 2.825/1.0916 + 3.625/1.0916^2 + 124.8/1.0916^3

                     = $101.18 million

            Equity value to Harrison            = Vops – Debt

                                                               = 101.18 million – 11.85 million

                                                               = 89.73 million

            or $89.73 per share since there are 1 million shares outstanding.

The bid for each share should range between $   17.97_______ per share and $   __89.73______ per share

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.