Question

2. 2. A firm has the following three projections of revenue estimates:

Current Year1 Year 2 Year 3

Revenue $1,500 $1,650 $1,815 $2,000

EAT $95 $106 $117 $130

The company also receives a royalty net after taxes of $10 million per year. It is expected that the cash flows equal to depreciation will have to be reinvested to keep the firm operating. Further, capital expenditures equal to 60 percent of the net cash flow will need to be invested to keep the firm growing. Other items on the balance sheet remain unchanged. The CFO believes that it will just forecast for the first three years and then simply assume a 6 percent annual growth rate after the third year.

T-bills yield 8 percent and the market return is 13 percent. The company’s beta using Hamada equation is 1.2. What is the value of the company or what would you pay for the firm if you were interested in it.

Answer 1

Free cash flow to the firm = EAT + Royalty + Depreciation - maintenance capex - growth capex - increase in working capital

Depreciation = maintenance capex

Growth capex = 60% of (EAT + Royalty)

Increase in working capital = 0

Hence, free cash flow = EAT + Royalty - 60% of (EAT + Royalty) = 40% of (EAT + Royalty)

Formula Spreadsheet

The value of company = $618.42 Millions