Question

Firm Valuation 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 $6.8 million. The cash flows are expected to grow at 8% for the next 5 years before leveling off to 4% for the indefinite future. The cost of capital for Shultz and Arras is 12% and 10%, respectively. Arras currently has 2.4 million shares of stock outstanding and $25 million in debt outstanding. What is the maximum price per share Schultz should pay for Arras?

Required:

1. First calculate the annual cash flows for years 1 through 6:

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

2. Calculate the terminal value in year 6, since that is when cash flows become perpetual.

TV5 = CF6/(RWACC – g)

Terminal Value =

3. Discount the cash flows for the 5 years plus the terminal value back to today. The total is equal to the market value of the company.

Year 1

Year 2

Year 3

Year 4

Year 5

MV of Company =

4. Calculate the market value of equity and price per share.

MV of equity =

Price per share =

Answer 1

1.

	Annual Cash Flows	Formula
Year 0	6.80
Year 1	7.34	6.8*(1+8%)
Year 2	7.93	6.8*(1+8%)^2
Year 3	8.57	6.8*(1+8%)^3
Year 4	9.25	6.8*(1+8%)^4
Year 5	9.99	6.8*(1+8%)^5
Year 6	10.39	6.8*(1+8%)^5*(1+4%)

2.
Discount rate =10%(Arras Cost of Capital
Terminal Cash Flow= CF6/(RWACC – g) = 10.391088/(10%-4%) =173.18

3.

	Annual Cash Flows	Terminal Value	Total Cash Flows	Discounted cash Flows	Formula
Year 1	7.34		7.34	6.68	7.34/1.1
Year 2	7.93		7.93	6.55	7.93/1.1^2
Year 3	8.57		8.57	6.44	8.57/1.1^3
Year 4	9.25		9.25	6.32	9.25/1.1^4
Year 5	9.99	173.18	183.18	113.74	113.78/1.1^5
Year 6	10.39
			Total MV of company	139.72	Sum of all discounted cash flows

4. MV of equity = MV of Company - Total Debt = 139.72 -25 = 114.72
Price Per Share = MV of Equity/Total no of Shares = 114.72/2.4 = 47.80