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) Calculate free cash flow each year from the below formula

FCF = EBIT * (1-Tax) - Change in Net working capital - Capital spending + Depreciation

In Year 5, EBIT = 16.64*(1+10%) + EBIT for perpetuity

EBIT for perpetuity = 16.64*(1+10%)*(1+3%) / (9.04%-3%) = 283.46

So EBIT in 5th year = 18.30 + 283.46 = 301.76

9.04% is WACC calculated as below

WACC = (140/520) * 6% * (1-38%) + (380/520) * 11% = 9.04%

So NPV of FCF's can be calculated as NPV(9.04%,G2:G6) = $111.43

Value of Joe's firm is $111.43 million

Share price Happy times willing to pay = 111.43 / 1.85 = $60.23

b) EBITDA in year 6 = 18.85 + 18.85*(1+8%) = 20.36

EBITDA = EBIT + Depreciation

EV / EBITDA is given as 8, so EV = 20.36 * 8 = 162.87

Value of firm now is PV(5th year value) = 162.87 / (1+9.04%)5 = 105.66

PV's of cash flows are calculated above as 26.83

So total value of firm = 26.83 + 105.66 = 132.49 million

Share value = 132.49 / 1.85 = 71.62

Year EBIT EBIT(1-t) NWC Capex Depreciation FCF 1 12.50 7.75 1.13 1.88 1.00 5.75 2 13.75 8.53 1.24 2.06 1.10 6.33 3 15.13 9.38 1.36 2.27 1.21 6.96 4 16.64 10.32 1.50 2.50 1.33 7.65 5 301.76 187.09 27.16 45.26 24.14 138.81

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.