Happy Times, Inc., wants to expand its party stores into the Southeast. In order

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

a) Maximum share price = $49.42 Joe's Party Supply: 1 2 3 4 5 6 7+ EBIT ($ millions) 16.00000 17.28000 18.66240 20.15539 21.76782 23.50925 24.44962 Tax @ 30% 4.80000 5.18400 5.59872 6.04662 6.53035 7.05277 7.33489 EBIT (1-t) 11.20000 12.09600 13.06368 14.10877 15.23748 16.45647 17.11473 Add: depreciation 0.96000 1.03680 1.11974 1.20932 1.30607 1.41055 1.46698 Cash flow from operations 12.16000 13.13280 14.18342 15.31810 16.54355 17.86703 18.58171 Less: Increase in NWC (7% of EBIT) 1.12000 1.20960 1.30637 1.41088 1.52375 1.64565 1.71147 Capital spending (13% of EBIT) 2.08000 2.24640 2.42611 2.62020 2.82982 3.05620 3.17845 Free cash flows to firm 8.96000 9.67680 10.45094 11.28702 12.18998 13.16518 13.69179 pvif @ 10.92% (WACC of Happy Times Inc) 0.9015507 0.812794 0.732775 0.660633 0.595595 0.53695864 PV @ 10.92% (WACC of Happy Times Inc) 8.077894 7.865241 7.658186 7.456583 7.260286 7.06915691 PV of FCFF of years 1 to 6 45.387347 PV of continuing value = ((13.69179/(0.1092-0.04))*0.53695864 106.24169 Total value of Joe's Party supply 151.62904 Less: value of Joe's debt 35.50000 Value of Joe's equity 116.12904 # of shares of Joe's outstanding in millions 2.35 Maximum price of one share = 116.12904/2.35 $49.42 WACC of Happy Times: After tax cost of debt - Kd = 9*0.7 = 6.3% Cost of equity - Ke = 14% Total capitalisation = debt 240 + stock 360 = 600 WACC = 6.3*240/600 + 14*360/600 = 10.92% b) Maximum price of one share = $42.63 EBITDA of Joe's Party (EBIT+Depn = 16+0.96) 16.96 EV/EBITDA multiple 8 EV of Joe's party 135.68 Less: MV of debt 35.50 Value of Joe's equity 100.18 # of shares of Joe's outstanding in millions 2.35 Maximum price of one share = 100.18/2.35 $42.63

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