Happy Times, Inc. wants to expand its party stores into the Southeast. In order

Question

Happy Times, Inc. wants to expand its party stores into the Southeast. In order to establish an immediate presence in the area, the company is considering purchasing a privately-held firm called Joe’s Party Supply. Happy times currently has debt outstanding with a market value of $140 million and a YTM of 6%. The company’s market capitalization is $380 million, and the required return on equity is 11%. Joe’s currently has debt outstanding with a market value of $30.5 million. The EBIT for Joe’s next year is projected to be $12.5 million. EBIT is expected to grow at 10% per year for the next 5 years before slowing down to 3% in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 9%, 15%, and 8%, respectively. Joe’s has 1.85 million shares among its limited owners and both companies face a 38% tax rate.

a) Based on these estimates, what is the maximum share price that Happy Times should be willing to pay for Joe’s?

b) After examining your analysis, the CFO of Happy Times is uncomfortable using the perpetual growth rate in cash flows. Instead, she feels that the terminal value should be estimated using the multiple EV/EBITDA (i.e. “enterprise value” to “earnings before interest, taxes, depreciation, and amortization”). If the appropriate multiple is 8, what is your new estimate of the maximum share price for the purchase?

Explanation / Answer

a) Based on these estimates, what is the maximum share price that Happy Times should be willing to pay for Joe’s?

WACC = Weight of Common Stock* Cost of Common Stock+ Weight of Debt* After Tax cost of Debt

WACC = 380/(380+30.5) * 11% + 30.5/(380+30.5) * 6%*(1-38%)

WACC = 10.4591%

Expected EBIT = $ 12.5 Million

Net working capital = 9%*12.5 = 1.125

capital spending = 15%*12.5 = 1.875

Depreciation = 8%*12.5 =1

FCF 1 = Expected EBIT *(1-tax rate)+ Depreciation - Net working capital - capital spending

FCF 1 = 12.5*(1-38%) + 1 - 1.125 - 1.875

FCF 1= $ 5.75 Million

Enterprises Value = FCF 1/(1+WACC) +FCF 2/(1+WACC)^2  +FCF 3/(1+WACC)^3 +FCF 4/(1+WACC)^4  + FCF 5/(1+WACC)^5  +(FCF 6/(WACC-g))/(1+WACC)^2

Enterprises Value = 5.75/1.104591+  5.75*1.10/1.104591^2 + 5.75*1.10^2/1.104591^3 + 5.75*1.10^3/1.104591^4  + 5.75*1.10^4/1.104591^5 + (5.75*1.10^4*1.03/(10.4591%-3%))/1.104591^5

Enterprises Value = $ 96.5062 Million

Maximum share price that Happy Times = (Enterprises Value-debt) /No of outstanding share

Maximum share price that Happy Times = 96.5062/1.85

Maximum share price that Happy Times = $ 52.17

b) After examining your analysis, the CFO of Happy Times is uncomfortable using the perpetual growth rate in cash flows. Instead, she feels that the terminal value should be estimated using the multiple EV/EBITDA (i.e. “enterprise value” to “earnings before interest, taxes, depreciation, and amortization”). If the appropriate multiple is 8, what is your new estimate of the maximum share price for the purchase?

Enterprises Value =EV/EBITDA * EBITDA

Enterprises Value = 8 * (12.5 + 8%*12.5)

Enterprises Value = $ 108 Million

Maximum share price that Happy Times = (Enterprises Value-debt) /No of outstanding share

Maximum share price that Happy Times = 108/1.85

Maximum share price that Happy Times = $ 58.38

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