The following information is available about Chiantivino Corp.(CC):
An activist investor is confident that by terminating CC's money-losing fortified wine division,she can increase free cash flow by $4 million annually for the next decade.In addition,she estimates that an immediate,special dividend of $10 million can be financed by the sale of the division.
a.Assuming these actions do not affect CC's cost of capital,what is the maximum price per share the investor would be justified in bidding for control of CC?
What percentage premium does this represent?
b.Show your answer if you conduct a sensitivity analysis by assuming the cost of capital is 15 percent and the increased cash flow is only $3.5 million per year.

Question

The following information is available about Chiantivino Corp.(CC):
  An activist investor is confident that by terminating CC's money-losing fortified wine division,she can increase free cash flow by $4 million annually for the next decade.In addition,she estimates that an immediate,special dividend of $10 million can be financed by the sale of the division.
a.Assuming these actions do not affect CC's cost of capital,what is the maximum price per share the investor would be justified in bidding for control of CC?
 What percentage premium does this represent?
b.Show your answer if you conduct a sensitivity analysis by assuming the cost of capital is 15 percent and the increased cash flow is only $3.5 million per year.

Quizplus · Accepted Answer

The Answer is a.The maximum justifiable premium = the fair market value of CC under new management - the fair market value of CC under existing management.A plausible estimate of CC's fair market value under existing management is its standalone value = current market value of firm = $8 x 10 million + 75 million = $155 million.
Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of the division.
b.Fair market value = $155 million + $4 million x 5.216 + $10 million = $185.86.Fair market value of equity = $185.86 - 75 = $110.86.Fair market of equity per share = $110.86/10 = $11.09.This is a 38.6% premium over the existing $8 share price.
Fair market value of the firm assuming a 15 percent discount rate and a $3.5 million annuity = 155 + 3.5(5.019)+ 10 = $182.57 million.Value of equity = 182.57 - 75 = 107.57.Value per share = 107.57/10 = $10.76.This is a 34.5% premium over the existing price.

The Following Information Is Available About Chiantivino Corp.(CC)