Question

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.

1. What is Vandell’s cost of equity? Do not round intermediate calculations. Round your answer to two decimal places.

     %

2. What is its weighted average cost of capital? Do not round intermediate calculations. Round your answer to two decimal places.

     %

3. 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.

   $    million

4. 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

Answer 1

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