Harrison Corporation is interested in acquiring Van Buren Corporation. Assume th

Question

Harrison Corporation is interested in acquiring Van Buren Corporation. Assume that the risk-free rate of interest is 3% and the market risk premium is 4%.

Van Buren currently expects to pay a year-end dividend of $2.55 a share (D1 = $2.55). Van Buren's dividend is expected to grow at a constant rate of 4% a year, and its beta is 0.5.

Harrison estimates that if it acquires Van Buren, the year-end dividend will remain at $2.55 a share, but synergies will enable the dividend to grow at a constant rate of 8% a year (instead of the current 4%). Harrison also plans to increase the debt ratio of what would be its Van Buren subsidiary-the effect of this would be to raise Van Buren's beta to 1.4.

If Harrison were to acquire Van Buren, what would be the range of possible prices that it could bid for each share of Van Buren common stock?
Round your answers to the nearest cent.
a. Low bound $   
b. High bound $  

.

Explanation / Answer

Harrison corp can pay a range of value between two values : lower bound- standalone value of Van Buren

higher bound - value of van buren with synergy

lower bound- standalone value of Van Buren:

expected return = risk-free rate + beta * (market risk premium)

= 3+0.5*4 = 5%

Price = year end dividend/( required rate of return - growth rate)

=2.55/(0.05-0.04) =$ 255

higher bound - value of van buren with synergy

expected return = risk-free rate + beta * (market risk premium)

= 3+1.4*4 = 8.6%

Price = year end dividend/( required rate of return - growth rate)

=2.55/(0.086-0.08) =$ 425

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