Merger Valuation with Change in Capital Structure Hastings Corporation is intere
ID: 2719541 • Letter: M
Question
Merger Valuation with Change in Capital Structure
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%. Assume that the risk-free rate of interest is 5% and the market risk premium is 4%. 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. Suppose Hastings will increase Vandell's level of debt at the end of Year 3 to $34.7 million so that the target capital structure will be 45% debt. Assume that with this higher level of debt the interest rate would be 8.0%, and assume that interest payments in Year 4 are based on the new debt level from the end of Year 3 and new interest rate. Again, free cash flows and tax shields are projected to grow at 5% after Year 4.
What is the value of the unlevered firm? 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.
$ million
What is the value of the tax shield? 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.
$ million
What is the maximum price that Hastings would bid for Vandell now? 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.
$ million
Explanation / Answer
Year 3: 3.5 million + 525,000 = 4.025 million
year 4 :3.94million+525000+49.60 million=94.25 million
FCF1 = $2.3 million, FCF2 = $3.2 million and FCF3 = $3.5 millionfcf4=3.94; g = 5%; b = 1.4; rRF = 4%; RPM = 7%; wd = 30%; T = 35%; rd = 7.3% Vops = ? P0 = ? Horizon Value3 = FCF4(1+g)/(WACC -g) = 3.94 (1.04)/(.0908 - 0.04) = $49 .60million Tax shields in years 1 through 3 are: TS1 = TS2 = TS3 = Interest x T = 1,500,000 x 0.35 = 525,000 FCF + Tax Shield + Horizon Value Year 1: 2.3 million + 525,000 = 2.825 million Year 2: 3.2 million + 525,000 = 3.725 millionYear 3: 3.5 million + 525,000 = 4.025 million
year 4 :3.94million+525000+49.60 million=94.25 million
The unlevered cost of equity based on the pre-merger required rate of return and pre-merger capital structure is: rsU = wdrd + wsrsL Note: rs was calculated in problem 1 to be 13.4% = 0.3*(7.3%)+0.7*(10.5%) = 9.54% The present value of the FCFs, the tax shields, and the horizon value at the unlevered cost of equity is: Vops = 3.06 + 3.46 + 73.56 1+0.0954 1+0.0954^2 1+0.0954^3 Tax shields = $61.64 million Equity value = Vops - Debt = 61.64 million - 11.88 million Equity Value = 49.76 million or $49.76 per share since there are 1 million shares outstanding.