Merger Bid (PLEASE NOTE THAT NUMBERS ARE DIFFERENT THATN IN TEXTBOOK) Hastings C
ID: 2763709 • Letter: M
Question
Merger Bid (PLEASE NOTE THAT NUMBERS ARE DIFFERENT THATN IN TEXTBOOK)
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 7.7%. Assume that the risk-free rate of interest is 6% and the market risk premium is 7%. Both Vandell and Hastings face a 30% tax rate.
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Vandell's free cash flow (FCF0) is $1 million per year and is expected to grow at a constant rate of 6% a year; its beta is 1.25.
Hastings estimates that if it acquires Vandell, interest payments will be $1,600,000 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 $1.412 million after which interest and the tax shield will grow at 6%. Synergies will cause the free cash flows to be $2.4 million, $2.7 million, $3.4 million, and then $3.56 million, after which the free cash flows will grow at a 6% rate. Assume Vandell now has $11.72 million in debt.
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Indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition. Round your answers to the nearest cent. Do not round intermediate calculations.
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The bid for each share should range between $ ________ per share and $ ________ per share.
Explanation / Answer
Solution:
Given that FCF1 = 1.00(1.06) = $1.06 million; g = 5%; b = 1.25; rRF = 6%; RPM = 7%; wd = 30%; T = 30%; rd = 7.7%
rs = rRF + RPM(b)
= 6% + 7%(1.25)
= 14.75%.
WACC = wdrd(1-T) + wsrs
= 0.30(7.7%)(0.70) + 0.70(14.75%)
= 11.94%
Vops = FCF0 (1 + g)/ (WACC – g)
= $1.06/ (0.1194 – 0.05)
= $15.27 million
VS = Vops – debt
= 15.27 – 11.72 = $3.55 million
Price = 3.55 million / 1 million shares
= $3.55 / share.
Horizon Value3 = FCF3(1+g)/(WACC – g)
= 3.4 (1.06)/(.1194 – 0.05)
= $51.93 million
Tax shields in years 1 through 3 are:
TS1 = TS2 = TS3 = Interest x T
= 1,600,000 x 0.30
= 480,000
FCF + Tax Shield + Horizon Value =
Year 1: 2.4 million + 480,000 = 2.88 million
Year 2: 2.7 million + 480,000 = 3.18 million
Year 3: 3.4 million + 480,000 + 51.93 million = 55.81 million
The unlevered cost of equity based on the pre-merger required rate of return and pre-merger capital structure is:
rsU = wdrd + wsrsL
= 0.30(7.7%) + 0.70(14.75%)
= 12.635%
The present value of the FCFs, the tax shields, and the horizon value at the unlevered cost of equity is:
Vops = 2.88/1.1475 + 3.18/1.1475^2 + 55.81/1.1475^3
= $41.86 million
Equity value to Harrison = Vops – Debt
= 41.86 million – 11.72 million
= 30.14 million
or $30.14 per share since there are 1 million shares outstanding.
The bid for each share should range between $ 3.55_______ per share and $ __30.14______ per share