Question

Using: Free cash flow to equity (FCFE) approach

Wellington Industries is considering an acquisition of Orator Telecom Inc. Wellington Industries estimates that acquiring Orator will result in incremental value for the firm. The analysts involved in the deal have collected the following information from the projected financial statements of the target company.

Data Collected (in millions of dollars)
	Year 1	Year 2	Year 3
EBIT	$8.0	$9.6	$12.0
Interest expense	4.0	4.4	4.8
Debt	33.0	39.0	42.0
Total net operating capital	107.1	109.2	111.3

Orator is a publicly traded company, and its market-determined pre-merger beta is 1.00. You also have the following information about the company and the projected statements. • Orator currently has a $24.00 million market value of equity and $15.60 million in debt.
• The risk-free rate is 5% with a 7.10% market risk premium, and the Capital Asset Pricing Model produces a pre-merger required rate of return on equity r sL sL of 12.10%.
• Orator’s cost of debt is 7.00% at a tax rate of 30%.
• The projections assume that the company will have a post-horizon growth rate of 5.00%.
• Current total net operating capital is $104.0 million, and the sum of existing debt and debt required to maintain a constant capital structure at the time of acquisition is $30 million. • The firm has no nonoperating assets, such as marketable securities.

With the given information, use the free cash flow to equity (FCFE) approach to calculate the following values involved in the merger analysis. (Note: Round your answer to two decimal places.)

Value FCFE horizon value: ___ (Choices are: 93.79, 119.05, 106.20, 87.85)

Value of FCFE: _____ (Choices are: 89.39, 79.99, 74.99, 28.75)

The estimated value of Orator’s operations after the merger is _(more/less)___ than the market value of Orator’s equity. This means that the wealth of Orator’s shareholders will _(increase/decrease)_____if it merges with Wellington rather than remaining as a stand-alone corporation.

True or False: Like the corporate valuation model, the FCFE model can be applied only when the capital structure is constant. (True/ False)

Answer 1

Using the given information in the question, below table was contructed on Excel:

All other information in the above table is as per projected Financial statements, except Debt required of 30 million. As FCFE requires constant capital structure, hence, the total debt at the time of acquisition needs to be 30 million instead of 15.6 million given in Debt section.

Further using the information on Beta, risk premium, debt and equity, below table was constructed where useful things in FCFE calculations were Tax rate, Cost of Equity and Post-Horizon growth rate:

As we have EBIT, Interest expense and tax rate, and FCFE requires Net Income for calculation, we have calculated Net Income using ((EBIT - Interest Expense) * (1 - Tax Rate)) formula, which will help us reach Free cashflow to Equity.

Below are the Net Income calculated:

Next we need Free cashflow to Equity which uses below formula:

FCFE = Net Income - (Capital Expenditure - Depreciation) - (Change in Operating Capital) + (New Debt issue - Debt Repayments)

Since no Capex or Depreciation information is given, hence, we will ignore that part.

For example, first FCFE can be calculated by given calculation = 2.8 - (107.1 - 104) + (33 - 30) = 2.70

Below are the FCFEs:

Next we will calculate Value FCFE Horizon value which is also known as Terminal Value.

The formula that we use for Horizon Value = (FCFE₃) * (1 + Post-Horizon Growth) / (Cost of equity - Post Horizon growth)

Horizon Value for our question can be calculated as follows = (5.94 * (1 + 5%)) / (12.1% - 5%) = 6.24 / 0.071

The FCFE Horizon Value = 87.85

The Horizon Value uses Perpetuity Formula which first forecasts 4th Year Cashflow and predicts its perpetual using post-horizon value at Year 3. Hence, Horizon value is at 3rd Year

Next we will calculate the Present Values of all the cashflows, which can be calculated by discounting them by cost of equity of 12%

Year 1 FCFE = 2.7 / (1+ 12.1%)¹ = 2.41

Year 2 FCFE = 7.54 / (1+ 12.1%)² = 6.00

Year 2 FCFE = 5.94 / (1+ 12.1%)³ = 4.22

Similarly, Present Value of Horizon Value = 87.85 / (1+12.1%)³ = 62.36

Adding the all the present values, we will get the FCFE Value of Orator

FCFE Value of Orator = 74.98

Since, Value of Equity of Orator after merger is more than the market value of Orator's equity, hence, it will increase the wealth of Orator's shareholders.

True, FCFE requires the capital structure to be constant which is one of it's limitation and cannot be used for valuation of cyclical companies since their capital structure changes a lot.