Schultz Industries is considering the purchase of Arras Manufacturing. Arras is

Question

Schultz Industries is considering the purchase of Arras Manufacturing. Arras is currently a supplier for Schultz, and the acquisition would allow Schultz to better control its material supply. The current cash flow from assets for Arras is $8.4 million. The cash flows are expected to grow at 8 percent for the next five years before leveling off to 5 percent for the indefinite future. The cost of capital for Schultz and Arras is 12 percent and 10 percent, respectively. Arras currently has 3 million shares of stock outstanding and $25 million in debt outstanding. What is the maximum price per share Schultz should pay for Arras?

Explanation / Answer

We are given the total cash flow for the current year. To value the company, we need to calculate the cash flows until the growth rate levels off at a constant perpetual rate. So, the cash flows each year will be

Year 1: $8,400,000(1 + .08)= $9,072,000
Year 2: $9,072,000(1 + .08)= $9,797,760
Year 3: $9,797,760(1 + .08)= $10,581,581
Year 4: $10,581,581(1 + .08)= $11,428,107
Year 5: $11,428,107(1 + .08)= $12,342,356
Year 6: $12,342,356(1 + .05)= $12,959,474

Their present value would be

Year 1: $9,072,000 * 0.90909 = 8247264.48

Year 2: $9,797,760 * 0.826446 = 8097319.56

Year 3: $10,581,581 * 0.751314 = 7950089.95

Year 4: $11,428,107 * 0.683013 =7805545.65

Year 5: $12,342,356 * 0.620921 = 7663628.03

PV of cash flow from 1 to 5 years = 39763847.67

Continuing value of cash flow= $12,342,356*(1 + .05) / [0.10 - 0.05]

= 259189476

Present value of continuing value = 259189476 * 0.620921 = 160,936,188.63

Value of the firm = 39763847.67 + 160936188.63 = 200,700,036.3

Less- Value of debt = 25,000,000

VAlue of equity = 175,700,036.3

Shares outstanding = 3000000

Value of one share = 58.573

Maximum price per share Schultz should pay for Arras = 58.57

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