Happy Times, Inc., wants to expand its party stores into the Southeast. In order
ID: 2766183 • 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 $220 million and a YTM of 7 percent. The company’s market capitalization is $460 million, and the required return on equity is 12 percent. Joe’s currently has debt outstanding with a market value of $34.5 million. The EBIT for Joe’s next year is projected to be $14.0 million. EBIT is expected to grow at 10 percent per year for the next five years before slowing to 3 percent in perpetuity. Increases in net working capital and capital spending as a percentage of EBIT are expected to be 9 percent and 15 percent, while depreciation is expected to be 8 percent of EBIT. Joe’s has 2.25 million shares outstanding and the tax rate for both companies is 38 percent.
What is the maximum share price that Happy Times should be willing to pay for Joe’s? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
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 10.
What is your new estimate of the maximum share price for the purchase? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
What is the maximum share price that Happy Times should be willing to pay for Joe’s? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
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 10.
What is your new estimate of the maximum share price for the purchase? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
Explanation / Answer
a.
EBIT for year 1 = $14,000,000
Tax rate = 38%
Net income = EBIT * (1 – tax rate) = $14,000,000 * (1 - 0.38) = $8,680,000
Operating cash flow = Net income + Tax savings on Depreciation = Net income + (EBIT*0.08*0.38) = $8,680,000 + ($14,000,000*0.08*0.38) = $9,800,000
Increase in net working capital = EBIT * 0.09 = $14,000,000 * 0.09 = $1,260,000
Capital spending = EBIT * 0.15 = $17,000,000 * 0.15 = $2,100,000
Free cash flow for year 1 = Operating cash flow – Increase in net working capital – Capital spending = $9,800,000 - $1,660,000 - $2,100,000 = $6,440,000
The EBIT is expected to grow by 10% for first five years and 3% thereafter. Since all the cash flows are directly related to EBIT, the free cash flows shall also increase by same growth rate. Thus the free cash flows for next 6 years are as below:
Year
Growth rate
Free cash flow
1
$6,440,000.00
2
10%
$7,084,000.00
3
10%
$7,792,400.00
4
10%
$8,571,640.00
5
10%
$9,428,804.00
6
3%
$9,711,668.12
The above cash flows shall be discounted using the weighted average cost of capital to find the value of the company.
Market value of debt = $220 million
Market value of equity = $460 million
Weight of debt = 220/(220+460) = 0.32
Weight of equity = 460/(220+460) = 0.68
Cost of debt = YTM * (1-tax rate) = 7% * (1-0.38) = 4.34%
Cost of equity = 12%
Weighted average cost of capital = (4.34% * 0.32) + (12% * 0.68) = 9.55%
Value of firm at the end of year 5 = Cash flow at year 6/(WACC – Growth rate) = $9,711,668.12/(0.0955– 0.03) = $148,269,742.29
Year
Free cash flow
Present value factor @ 9.55%
Present value
1
$64,40,000.00
0.9128
$58,78,432.00
2
$70,84,000.00
0.8332
$59,02,388.80
3
$77,92,400.00
0.7606
$59,26,899.44
4
$85,71,640.00
0.6943
$59,51,289.65
5
$94,28,804.00
0.6338
$59,75,975.98
5
$14,82,69,742.29
0.6338
$9,39,73,362.66
$12,36,08,348.53
Market value of Joe = $123,608,348.53
Market value of debt of Joe = $34,500,000
Value of equity = $123,608,348.53 - $34,500,000 = $89,108,348.53
No. of shares outstanding = 2,250,000 shares
Value per share = $89,108,348.53/2,250,000 = $39.60 per share
Maximum share price that Happy Times should be willing to pay for Joe’s is $39.60 per share
b.
To calculate the terminal value using the EV/EBITDA multiple we need to calculate the Year 5 EBITDA, which is EBIT plus depreciation,
EBIT for year 5 = EBIT for year 1 * 1.104 = $14,000,000 * 1.4641 = $20,497,400
Depreciation = EBIT * 0.08 = $20,497,400 * 0.08 = $1,639,792
EBITDA = EBIT + Depreciation = $20,497,400 + $1,39,792 = $22,137,192
We can now calculate the terminal value of the company using the Year 5 EBITDA, which will be:
Terminal value at year 5 = EBITDA * (EV/EBITDA multiple) = $22,137,192 * 10 = $221,371,920
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.
Year
Free cash flow
Present value factor @ 9.55%
Present value
1
$64,40,000.00
0.9128
$58,78,432.00
2
$70,84,000.00
0.8332
$59,02,388.80
3
$77,92,400.00
0.7606
$59,26,899.44
4
$85,71,640.00
0.6943
$59,51,289.65
5
$22,13,71,920.00
0.6338
$14,03,05,522.90
$16,39,64,532.79
Market value of Joe = $163,964,532.79
Market value of debt of Joe = $34,500,000
Value of equity = $163,964,532.79 - $34,500,000 = $129,464,532.79
No. of shares outstanding = 2,250,000 shares
Value per share = $129,464,532.79/2,250,000 = $57.54 per share
Maximum share price that Happy Times should be willing to pay for Joe’s is $57.54 per share
Year
Growth rate
Free cash flow
1
$6,440,000.00
2
10%
$7,084,000.00
3
10%
$7,792,400.00
4
10%
$8,571,640.00
5
10%
$9,428,804.00
6
3%
$9,711,668.12
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