Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has

Question

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 7.9%. Assume that the risk-free rate of interest is 7% and the market risk premium is 7%. Both Vandell and Hastings face a 35% tax rate. 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 $1,445 million after which interest and the tax shield will grow at 4%. Synergies will cause the free cash flows to be $2.4 million, $2.9 million, $3.5 million, and then $3.85 million in Years 1 through 4, respectively, after which the free cash flows will grow at a 4% rate. What is the unlevered value of Vandell? Vandell's beta is 1.10. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1, 200,000. Round your answer to two decimal places. Do not round intermediate calculations. What is the value of its tax shields? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1, 200,000. Round your answer to two decimal places. Do not round intermediate calculations. What is the per share value of Vandell to Hastings Corporation? Assume Vandell now has $8.69 million in debt. Round your answer to the nearest cent. Do not round intermediate calculations.

Explanation / Answer

Using CAPM formula we calculate expected return on equity.

Cost of equity = rs = Risk free rate of return + Beta*Marker Premium

                    = 7% + (1.1)*7%

                    = 14.7%

WACC       = Weight of debt*cost of debt*(1- Tax rate) + weight of equity*cost of equity

                   = 0.30*7.9%*(1-0.35) + 0.70*14.7%

                   = 1.5405%+10.29%

= 11.83%   

Now we calculate unlevered cost of equity

unlevered cost of equity = Weight of debt*cost of debt + weight of equity* cost of equity

           = 0.30*7.9%* + 0.70*14.7%

           = 12.66%

Horizon Value in year 4 = FCF4(1+g)/(WACC – g)

                                    = 3.85 (1.04)/(11.83% - 4%)

                                    = $4.004 mn/7.83%

= $51.14 mn

Tax shields in years 1 to 3 year will remain same as interest payment and year4 will be different. Tax rate remain same.

                       Tax Shield for 1 to 3year / per annum year = Interest payment * Tax rate

                                     =( 1,500,000 * 35%)

                                     = $525,000

Tax Shield for 4th year = $1445,000 *35% = $505,750

FCF + Tax Shield + Horizon Value =

                                Year 1: 2.4 million +$525,000 =2.925 million

                                Year 2: 2.9 million + $525,000 = 3.425million

                                Year 3: 3.5 million + $525,000 =4.025 million

Year 4: 3.85 million +$505,750 + $51.14 mn =55.50 million

Unlevered value of Vandell can be calculated as PV of all (FCF + Tax Shield + Horizon Value) discounted at unlevered cost of equity.

            Unlevered value     = 2.925/(1.1266) + 3.425./(1.1266)^2 +4.025 /(1.1266)^3+55.50/(1.1266)^4

                     = $42.56 million

Equity value = Unlevered value – Debt

= 42.56 mn - 8.69mn

= 33.87 mn

            EPS = 33.87 mn / 1 million =$33.87 per share

Value of tax shield= Tax Shield for 1 to 3year = $525,000

Tax Shield for 4th year = $1445,000 *35% = $505,750

Tax Shield horizon value =$505,750(1.04) /(12.66%-4%) =$6,073,672

Tax Shield value = $525,000*2.3749 + ($505,750+$6,073,672)*0.6208

= $1,246,797+$4084,505

=$5331,302

                                                              

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