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 the purchase of the privately held Joe’s Party Supply. Happy Times currently has debt outstanding with a market value of $230 million and a YTM of 10 percent. The company’s market capitalization is $290 million, and the required return on equity is 15 percent. Joe’s currently has debt outstanding with a market value of $27 million. The EBIT for Joe’s next year is projected to be $17.0 million. EBIT is expected to grow at 9 percent per year for the next five years before slowing to 2 percent in perpetuity. Increases in net working capital and capital spending as a percentage of EBIT are expected to be 8 percent and 14 percent, while depreciation is expected to be 7 percent of EBIT. Joe’s has 2.05 million shares outstanding and the tax rate for both companies is 30 percent. What is the maximum share price that Happy Times should be willing to pay for Joe’s?

$46.76

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 EV / EBITDA multiple. The appropriate EV / EBITDA multiple is 9. What is your new estimate of the maximum share price for the purchase?

Explanation / Answer

Part 1:

Since both companies are in same industry, WACC could be same.

Total capital = 230 + 290 = 520

WACC of Happy Times = (230/520)*10*(1 - 0.3) + (290/520)*15 = 11.4615%

Compute value for Joe

Compute 1st year FCFF

FCFF = EBIT*(1 - T) + Depre - FCInv - WCInv

FCFF = 17*(1 - 0.3) + 0.07*17 - 0.14*17 - 0.08*17 = 9.35

Firm’s value = (9.35/(0.114615 - 0.09)) * (1 - 1.09^5/1.114615^5) + (9.35*1.09^4*1.02/(0.114615 - 0.02)) * (1/1.114615^5) = 122.84

Debt value = $27

Equity value = 122.84 - 27 = $95.84

Share price = 95.84/ 2.05 = $46.76

Part 2:

EV/EBITDA = 9

At t = 5, EBITDA = (17 + 0.07*17)*1.09^4 = 25.6767

At t = 5, EV = 9*25.6767 = 231.09

Terminal value = 231.09

Firm’s value = (9.35/(0.114615 - 0.09)) * (1 - 1.09^5/1.114615^5) + 231.09/1.114615^5 = 174.46

Equity value = 147.46

Share price = 147.46 / 2.05 = $71.93

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