Question

Valuation of Merger Target

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.45 (given its target capital structure). Vandell has $9.68 million in debt that trades at par and pays an 7.8% interest rate. Vandell’s free cash flow (FCF₀) is $1 million per year and is expected to grow at a constant rate of 5% a year. Vandell pays a 35% combined federal and state tax rate. The risk-free rate of interest is 3% and the market risk premium is 4%. Hastings’ first step is to estimate the current intrinsic value of Vandell.

1. What are Vandell’s cost of equity and weighted average cost of capital? Round your answer to two decimal places. Do not round intermediate calculations.
   Cost of equity:  %
   WACC:  %

2. What is Vandell's intrinsic value of operations? (Hint: Use the free cash flow corporate valuation model.) Round your answer to two decimal places. Do not round intermediate calculations.
   $    million

3. What is the current intrinsic value of Vandell's stock? Round your answer to the nearest cent. Do not round intermediate calculations.
   $   /share

Answer 1

a

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 3 + 1.45 * (4)

Cost of equity% = 8.8

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 7.8*(1-0.35)

= 5.07

Weight of equity = 1-D/A

Weight of equity = 1-0.3

W(E)=0.7

Weight of debt = D/A

Weight of debt = 0.3

W(D)=0.3

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5.07*0.3+8.8*0.7

WACC% = 7.68

b

firm or enterprise value= recent FCF* (1 + growth rate )/(WACC - growth rate)

Firm/enterprise value = 1 * (1+0.05) / (0.0768 - 0.05)

Firm/enterprise value = 39.18

c

Enterprise value = Equity value+ MV of debt

39.18 = Equity value+9.68

Equity value = 29.5 m

share price = equity value/number of shares

share price = 29.5/1

share price = 29.5