Merger bid Harrison Corporation is interested in acquiring Van Buren Corporation
ID: 2652367 • Letter: M
Question
Merger bid
Harrison Corporation is interested in acquiring Van Buren Corporation. Assume that the risk-free rate of interest is 5% and the market risk premium is 7%.
Van Buren currently expects to pay a year-end dividend of $2.70 a share (D1 = $2.70). Van Buren's dividend is expected to grow at a constant rate of 4% a year, and its beta is 0.9.
Harrison estimates that if it acquires Van Buren, the year-end dividend will remain at $2.70 a share, but synergies will enable the dividend to grow at a constant rate of 10% a year (instead of the current 4%). Harrison also plans to increase the debt ratio of what would be its Van Buren subsidiary-the effect of this would be to raise Van Buren's beta to 1.3.
If Harrison were to acquire Van Buren, what would be the range of possible prices that it could bid for each share of Van Buren common stock?
Round your answers to the nearest cent.
a. Low bound $
b. High bound $
.
Explanation / Answer
The stock price can be calculated with the use of Gordon's Dividend Growth Model. The formula for calculating the stock price using this model would be:
Stock Price = D1/(ke - g) where D1 = Dividend at the Year End, ke = Required Return and g = growth rate
ke will be calculated with the use of CAPM model, the formula is:
ke = Rf + b*(Rm - Rf) where Rf = Risk Free Rate, b = Beta and Rm = Market Rate of Return or Rm - Rf = Market Risk Premium
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Part a) Low Bound:
Using the information provided in the question, we get,
ke = 5 + .9*7 = 11.30%
Stock Price = 2.70/(11.30% - 4%) = $36.99 or $37
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Part b) High Bound:
Using the information provided in the question, we get,
ke = 5 + 1.3*7 = 14.10%
Stock Price = 2.70/(14.10% - 10%) = $65.85
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The range of possible prices would be ,therefore, between $36.99 (low bound) and $65.85 (high bound).