Intrinsic Value of Merger target
Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1.5 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.40 (given its target capital structure). Vandell has $11.41 million in debt that trades at par and pays a 7.2% interest rate. Vandell’s free cash flow (FCF0) is $1 million per year and is expected to grow at a constant rate of 4% a year. Vandell pays a 25% combined federal-plus-state tax rate, the same rate paid by Hastings. The risk-free rate of interest is 4%, and the market risk premium is 4%. Hasting’s first step is to estimate the current intrinsic value of Vandell.
What is Vandell’s cost of equity? Do not round intermediate calculations. Round your answer to two decimal places.
What is its weighted average cost of capital? Do not round intermediate calculations. Round your answer to two decimal places.
What is Vandell’s intrinsic value of operations? (Hint: Use the free cash flow corporate valuation model.) Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Do not round intermediate calculations. Round your answer to two decimal places.
Based on this analysis, what is the minimum stock price that Vandell’s shareholders should accept? Do not round intermediate calculations. Round your answer to the nearest cent.
$ / share
a. cost of equity=risk free rate+(beta*market risk premium)=4%+(1.4*4%)=9.6%
b. weighted average cost of capital (WACC)=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)
after tax cost of debt=interest rate*(1-tax rate)=7.2%*(1-25%)=5.4%
weight of debt=30%
weight of equity=1-30%=70%
weighted average cost of capital=(70%*9.6%)+(30%*5.4%)=8.34%
c. Intrinsic value of operations=FCF1/(WACC-growth rate)
FCF1=FCF0*(1+growth rate)=1 million*(1+4%)=1*1.04=1.04 million
Intrinsic value of operations=1.04/(8.34%-4%)=23.96 million
d. Stock price=( Intrinsic value of operations-value of debt)/outstanding shares=(23.96-11.41)/1.5=$8.37
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