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 6% and the market risk premium is 5%. Both Vandell and Hastings face a 40% 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 1.60.

Hastings estimates that if it acquires Vandell, interest payments will be $1,600,000 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 $1.442 million after which interest and the tax shield will grow at 4%. Synergies will cause the free cash flows to be $2.4 million, $2.7 million, $3.4 million, and then $3.97 million, after which the free cash flows will grow at a 4% rate. Assume Vandell now has $9.31 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.

Explanation / Answer

Value of shares without synergy:

Value of the firm = (FCFF0*1.04)/(WACC - 0.04)

= 2*1.04/(0.11096 - 0.04) = 29.31 million $

Less value of debt           =   9.31

Value of equity                = 20.00 million $

number of shares = i million

Value of one share = 20/1 = $20

Calculation of WACC:

after tax cost of debt = 7.2*0.6 = 4.32%

cost of equity = Risk free rate + beta*market risk premium = 6 + 1.6*5 = 14%

WACC = 4.32*0.3 + 14*0.7 = 1.296 + 9.8 = 11.096%

Value of shares with synergy:

(figures in million $) 1 2 3 4 FCFF 2.40 2.70 3.40 3.97 less: interest * 0.6 0.96 0.96 0.96 0.87 FCF to Equity 1.44 1.74 2.44 3.10 pvif @ 14% (cost of equity) 0.8772 0.7695 0.6750 0.5921 pv of the cash flows 1.26 1.34 1.65 1.84 sum of pv of cash flows - year 1 to 4 6.09 Horizon value = [3.10*1.04/(0.14 - 0.04)]*0.5921 19.09 value of equity 25.18 value of one share $    25.18 Therefore, the range of bid should be $20 to $25.18 for each share.

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