Kellog wants to expand its cereal business by acquiring Major foods company. Kel

Question

Kellog wants to expand its cereal business by acquiring Major foods company. Kellog currently has debt outstanding with a market value of $150 million and a YTM of 7 percent. The company’s market capitalization is $390 million, and the required return on equity is 12 percent. Major foods has debt outstanding with a market value of $32 million. The EBIT for Major Foods is projected to be $14 million. EBIT is expected to grow at 11 percent per year for the next five years before slowing to 2% in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 10 percent, 15 percent, and 9 percent, respectively. Major Foods has 2 million shares outstanding, and the tax rate for both companies is 40 percent. a. What is the maximum share price do you think Kellog should to pay for Major foods stock. b. Would you recommend that Kellog purchase Major foods? Why?

Explanation / Answer

a) 1) KELLOGS WACC: After tax cost of debt = 7*60% = 4.62% Cost of equity 12.00% WACC = 4.20*150/(150+390)+12.00*390/(150+390) = 9.83% 2) FCF of MAJOR FOODS: 0 1 2 3 4 5 EBIT (with 11% increase from year 1 to year 5) 14.00 15.54 17.249 19.147 21.253 23.591 Tax at 40% 6.216 6.9 7.659 8.501 9.436 NOPAT 9.324 10.35 11.488 12.752 14.154 Add: Depreciation (9% of EBIT) 1.399 1.552 1.723 1.913 2.123 OCF 10.723 11.902 13.211 14.665 16.278 Capital spending (15% of EBIT) 2.331 2.587 2.872 3.188 3.539 Change in NWC (10% of increase in EBIT) 0.154 0.171 0.19 0.211 0.234 (10% has been applied on the increase in EBIT. So for 1st year it is 10% of (15.540-14.000) = 0.154) FCF 8.238 9.144 10.15 11.266 12.505 PVIF at 9.83% 0.9105 0.82901 0.75481 0.68725 0.62574 PV at 9.83% 7.500 7.580 7.661 7.743 7.825 Sum of PV of FCF--t1 to t5 = 38.309 Continuing value of FCF at t5 = 12.505*1.02/(0.0983-0.02)= 162.900 PV of continuing value = 162.900*0.62574 = 101.933 Value of Major Foods 140.242 Less: Debt 32.000 Value of equity of Major foods 108.242 Number of shares in millions 2.000 Price per share (maximum) $54.12 Answer [a] b) The minimum price would be the price based on the valuation without merger. Kellog may pay a price in between the minimum and maximum. If the shares of Major foods is quoted, the quoted price can be compared with the minimum price to find whether the shares are under valued or overvalued in the market. The lowest of the market price or the minimum value calculated can be paid. ALTERNATIVE SOLUTION (WITH NWC AS A % OF EBIT) a) 1) KELLOGS WACC: After tax cost of debt = 7*60% = 4.62% Cost of equity 12.00% WACC = 4.20*150/(150+390)+12.00*390/(150+390) = 9.83% 2) FCF of MAJOR FOODS: 0 1 2 3 4 5 EBIT (with 11% increase from year 1 to year 5) 14.000 15.540 17.249 19.147 21.253 23.591 Tax at 40% 6.216 6.900 7.659 8.501 9.436 NOPAT 9.324 10.349 11.488 12.752 14.155 Add: Depreciation (9% of EBIT) 1.399 1.552 1.723 1.913 2.123 OCF 10.723 11.902 13.211 14.665 16.278 Capital spending (15% of EBIT) 2.331 2.587 2.872 3.188 3.539 Change in NWC (10% of EBIT) 1.554 1.725 1.915 2.125 2.359 FCF 6.838 7.590 8.425 9.351 10.380 PVIF at 9.83% 0.9105 0.82901 0.75481 0.68725 0.62574 PV at 9.83% 6.226 6.292 6.359 6.427 6.495 Sum of PV of FCF--t1 to t5 = 31.798 Continuing value of FCF at t5 = 10.380*1.02/(0.0983-0.02)= 135.218 PV of continuing value = 135.218*0.62574 = 84.612 Value of Major Foods 116.410 Less: Debt 32.000 Value of equity of Major foods 84.410 Number of shares in millions 2.000 Price per share (maximum) $      42.20 Answer [a] b) The minimum price would be the price based on the valuation without merger. Kellog may pay a price in between the minimum and maximum. If the shares of Major foods is quoted, the quoted price can be compared with the minimum price to find whether the shares are under valued or overvalued in the market. The lowest of the market price or the minimum value calculated can be paid.

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