Merger Valuation with Change in Capital Structure Hasting Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 5% rate.

Hasting plans to assume Vandell’s $10.82 million in debt and raise additional debt financing at the time of the acquisition. Hasting estimates that interest payments will be $1.5 million each year for Years 1, 2, and 3.

Unlike Problem 26-3, suppose Hasting will increase Vandell’s level of debt at Year 3 to $30.6 million so that the target capital structure becomes 45% debt. Assume that with this higher level of debt the interest rate would be 8.5%, and assume that interest payments in Year 4 are based on the new debt level at Year 3 and the 8.5% interest rate. The Year 4 interest expense is expected to grow at 5% after Year 4. As described in Problem 26-1, Vandell currently has 1 million shares outstanding and a target capital structure consisting of 30% debt; its current beta is 1.4 (i.e., based on its target capital structure).

a. What is the Year 4 interest expense? What is the Year 4 tax shield?

b. What is the unlevered value of operations? What is the value of the tax shield?k

c. What is the maximum price per share that Hasting would bid for Vandell? How does it compare with your answers to Problems 26-1 and 26-2?

Problem 26-1

Hasting Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.4 (given its target capital structure). Vandell has $10.82 million in debt that trades at par and pays an 8% interest rate. Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 5% a year. Vandell pays a 40% combined federal and state tax rate. The risk-free rate of interest is 5%, and the market risk premium is 6%. Hasting’s first step is to estimate the current intrinsic value of Vandell.

Problems 26-2

Hasting Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vanell’s free cash flows to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 5% rate. Hasting plans to assume Vandell’s $10.82 million in debt (which has an 8% interest rate) and raise additional debt financing at the time of the acquisition. Hasting estimates that interest payments will be $1.5 million each year for Years 1, 2, and 3.
After Year 3, a target capital structure of 30% debt will be maintained. Interest at Year 4 will be $1.472 million, after which the interest and the tax shield will grow at 5%. As described in Problem 26-1, Vandell currently has 1 million shares outstanding and a target capital structure consisting of 30% debt; its current beta is 1.4 (i.e., based on its target capital structure).