Happy Times, Inc., wants to expand its party stores into the Southeast. In order
ID: 2739616 • Letter: H
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 $130 million and a YTM of 9 percent. The company’s market capitalization is $270 million, and the required return on equity is 14 percent. Joe’s currently has debt outstanding with a market value of $26 million. The EBIT for Joe’s next year is projected to be $16 million. EBIT is expected to grow at 7 percent per year for the next five years before slowing to 5 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 6 percent, 12 percent, and 5 percent, respectively. Joe’s has 2.15 million shares outstanding, and the tax rate for both companies is 35 percent. a. What is the maximum share price that Happy Times should be willing to pay for Joe’s?
Explanation / Answer
Explanation:
a.
To begin the valuation of Joe’s, we will begin by calculating the RWACC for Happy Times. Since both companies are in the same industry, it is likely that the RWACC for both companies will be the same. The weights of debt and equity are:
XB = $130,000,000 / ($130,000,000 + 270,000,000) = .3250, or 32.50%
XS = $270,000,000 / ($130,000,000 + 270,000,000) = .6750, or 67.50%
The RWACC for Happy Times is:
RWACC = .3250(.09)(1 .35) + .6750(.14) = .1135, or 11.35%
Next, we need to calculate the cash flows for each year. The EBIT will grow at 7 percent per year for 5 years. Net working capital, capital spending, and depreciation are 6 percent, 12 percent, and 5 percent of EBIT, respectively. So, the cash flows for each year over the next 5 years will be:
Year 1
Year 2
Year 3
Year 4
Year 5
EBIT
$
16,000,000
$
17,120,000
$
18,318,400
$
19,600,688
$
20,972,736
Taxes
5,600,000
5,992,000
6,411,440
6,860,241
7,340,458
Net income
$
10,400,000
$
11,128,000
$
11,906,960
$
12,740,447
$
13,632,278
Depreciation
800,000
856,000
915,920
980,034
1,048,637
OCF
$
11,200,000
$
11,984,000
$
12,822,880
$
13,720,482
$
14,680,915
Capital spending
1,920,000
2,054,400
2,198,208
2,352,083
2,516,728
Change in NWC
960,000
1,027,200
1,099,104
1,176,041
1,258,364
Cash flow from assets
$
8,320,000
$
8,902,400
$
9,525,568
$
10,192,358
$
10,905,823
After Year 5 the cash flows will grow at 5 percent in perpetuity. We can find the terminal value of the company in Year 5 using the cash flow in Year 6 as:
TV5 = CF6 / (RWACC g)
TV5 = $10,905,823(1 + .05) / (.1135 .05)
TV5 = $180,297,012
Now we can discount the cash flows and terminal value to today. Doing so, we find:
V0 = $8,320,000 / 1.1135 + $8,902,400 / 1.11352 + $9,525,568 / 1.11353
+ $10,192,358 / 1.11354 + ($10,905,823 + 180,297,012) / 1.11355
V0 = $139,871,912
The market value of the equity is the market value of the company minus the market value of the debt, or:
S = $139,871,912 26,000,000
S = $113,871,912
To find the maximum offer price, we divide the market value of equity by the shares outstanding, or:
Share price = $113,871,912 / 2,150,000
Share price = $52.96
b.
To calculate the terminal value using the EV/EBITDA multiple we need to calculate the Year 5 EBITDA, which is EBIT plus depreciation, or:
EBITDA = $20,972,736 + 1,048,637
EBITDA = $22,021,373
We can now calculate the terminal value of the company using the Year 5 EBITDA, which will be:
TV5 = $22,021,373(9)
TV5 = $198,192,357
Note, this is the terminal value in Year 5 since we used the Year 5 EBITDA. We need to calculate the present value of the cash flows for the first 4 years, plus the present value of the Year 5 terminal value. We do not need to include the Year 5 cash flow since it is included in the Year 5 terminal value. So, the value of the company today is:
V0 = $8,320,000 / 1.1135 + $8,902,400 / 1.11352 + $9,525,568 / 1.11353
+ $10,192,358 / 1.11354 + $198,192,357 / 1.11355
V0 = $143,954,843
The market value of the equity is the market value of the company minus the market value of the debt, or:
S = $143,954,843 26,000,000
S = $117,954,843
To find the maximum offer price, we divide the market value of equity by the shares outstanding, or:
Share price = $117,954,843 / 2,150,000
Share price = $54.86
To begin the valuation of Joe’s, we will begin by calculating the RWACC for Happy Times. Since both companies are in the same industry, it is likely that the RWACC for both companies will be the same. The weights of debt and equity are:
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