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 $160 million and a YTM of 7 percent. The company’s market capitalization is $400 million, and the required return on equity is 12 percent. Joe’s currently has debt outstanding with a market value of $31.5 million. The EBIT for Joe’s next year is projected to be $14 million. EBIT is expected to grow at 8 percent per year for the next five years before slowing to 4 percent in perpetuity. Net working capital, capital spending, and depreciation as a percentage of EBIT are expected to be 7 percent, 13 percent, and 6 percent, respectively. Joe’s has 1.95 million shares outstanding and the tax rate for both companies is 30 percent.

a. 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 answer to 2 decimal places, e.g., 32.16.)

Maximum share price            $

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.

b. What is your new estimate of the maximum share price for the purchase? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Maximum share price            $

Answer 1

WACC calculation:

	Market value (MV)	Cost (k)	Weight (W) Mvdebt/Total MV; Mvequity/Total MV	Weighted cost (W*k)
Debt	160	4.90%	0.286	1.40%
Equity	400	12.00%	0.714	8.57%
Total	560		WACC	9.97%

Share price calculation (using DDM):

Formula	Year (n)	0	1	2	3	4	5	Perpetuity
	Growth rate (g)		8%	8%	8%	8%	8%	4%
	EBIT	12,880,000	14,000,000	15,120,000	16,329,600	17,635,968	19,046,845	19,808,719
30%*EBIT	Tax @ 30%		4,200,000	4,536,000	4,898,880	5,290,790	5,714,054	5,942,616
EBIT - Tax	Net income (NI)		9,800,000	10,584,000	11,430,720	12,345,178	13,332,792	13,866,103
6%*EBIT	Add: depreciation (D)		840,000	907,200	979,776	1,058,158	1,142,811	1,188,523
NI + D	Operating Cash Flow (OCF)		10,640,000	11,491,200	12,410,496	13,403,336	14,475,603	15,054,627
7%*EBIT	NWC	901,600	980,000	1,058,400	1,143,072	1,234,518	1,333,279	1,386,610
13%*EBIT	Capex	1,674,400	1,820,000	1,965,600	2,122,848	2,292,676	2,476,090	2,575,134
NWCn - NWCn-1	Less: Increase/(decrease) in NWC		78,400	78,400	84,672	91,446	98,761	53,331
Capexn - Capexn-1	Less: Increase/(decrease) in Capex		145,600	145,600	157,248	169,828	183,414	99,044
OCF - Increase in NWC - Increase in Capex	Free Cash Flow (FCF)		10,416,000	11,267,200	12,168,576	13,142,062	14,193,427	14,902,252
FCFperpetuity/(WACC - g)	Horizon value (HV)							249,559,242
FCF + HV	Total FCF		10,416,000	11,267,200	12,168,576	13,142,062	14,193,427	249,559,242
1/(1+WACC)^n	Discount factor @ WACC		0.909	0.827	0.752	0.684	0.622	0.622
Total FCF*Discount factor	PV of Total FCF		9,471,551	9,316,575	9,149,559	8,985,537	8,824,456	155,158,054
Sum of all PVs	Firm Value	200,905,732
	Less: debt	31,500,000
Firm Value - debt	Equity value	169,405,732
	Shares O/S	1,950,000
Equity value/Shares O/S	Price per share	86.87

a). Maximum share price = $86.87

Share price calculation (using exit multiple):

Formula		Year 5
	EBIT	19,046,845
	Depreciation (D)	1,142,811
EBIT + D	EBITDA	20,189,656
	EV/EBITDA multiple	10
EBITDA*multiple	FCF	201,896,562
1/(1+WACC)^5	Discount factor	0.622
FCF*Discount factor	Horizon EV	125,524,815

Formula	Year (n)	0	1	2	3	4	5
	Growth rate (g)		8%	8%	8%	8%	8%
	EBIT	12,880,000	14,000,000	15,120,000	16,329,600	17,635,968	19,046,845
30%*EBIT	Tax @ 30%		4,200,000	4,536,000	4,898,880	5,290,790	5,714,054
EBIT - Tax	Net income (NI)		9,800,000	10,584,000	11,430,720	12,345,178	13,332,792
6%*EBIT	Add: depreciation (D)		840,000	907,200	979,776	1,058,158	1,142,811
NI + D	Operating Cash Flow (OCF)		10,640,000	11,491,200	12,410,496	13,403,336	14,475,603
7%*EBIT	NWC	901,600	980,000	1,058,400	1,143,072	1,234,518	1,333,279
13%*EBIT	Capex	1,674,400	1,820,000	1,965,600	2,122,848	2,292,676	2,476,090
NWCn - NWCn-1	Less: Increase/(decrease) in NWC		78,400	78,400	84,672	91,446	98,761
Capexn - Capexn-1	Less: Increase/(decrease) in Capex		145,600	145,600	157,248	169,828	183,414
OCF - Increase in NWC - Increase in Capex	Free Cash Flow (FCF)		10,416,000	11,267,200	12,168,576	13,142,062	14,193,427
FCFperpetuity/(WACC - g)	Horizon value (HV)
FCF + HV	Total FCF		10,416,000	11,267,200	12,168,576	13,142,062	14,193,427
1/(1+WACC)^n	Discount factor @ WACC		0.909	0.827	0.752	0.684	0.622
Total FCF*Discount factor	PV of Total FCF		9,471,551	9,316,575	9,149,559	8,985,537	8,824,456
Sum of all PVs + Horizon EV	Firm Value	171,272,493
	Less: debt	31,500,000
Firm Value - debt	Equity value	139,772,493
	Shares O/S	1,950,000
Equity value/Shares O/S	Price per share	71.68

Maximum share price (using exit multiple) = $71.68