Question

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 per cent 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)

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row highlighted in yellow is your answer. Figures in parenthesis, if any, mean negative values. All financials are in $ mn. Adjacent cells in blue contain the formula in excel I have used to get the final output.

the value of the company or what would you pay for the firm if you were interested in it = $ 618.42 mn