Question

You have been asked by an investor to value a restaurant using discounted cash flow valuation. For the current year, the restaurant earned pretax operating income of $750,000. Income has grown 2% annually during the last five years, and is expected to continue growing at that rate for the next two years. Net operating working capital increased by $60,000 during the current year and current year capital spending on long-lived assets exceeded depreciation by $75,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. Subsequent to the second year, you believe the pretax operating income growth rate will increase to 3% per year and remain at that level into the foreseeable future. The 10-year Treasury bond rate is 2.5%, the equity risk premium is 5.5%, and the marginal federal, state, and local tax rate is 35%. The restaurant’s beta and its target debt-to-equity ratio are 1.74 and 0.67, respectively. Its pretax cost of borrowing, based on its recent borrowing activities, is 9%. (Show Work)

What is the restaurant’s enterprise free cash flow in year 1?

A)$352,500 B)$420,750 C)$427,500 D)$359,550 E)$436,050

What is the restaurant’s enterprise free cash flow in year 2?

A)$370,337 B)$359,550 C)$436,050 D)$366,741 E)$388,745

What is the restaurant’s cost of equity?

A)14.5% B)12.07% C)7.72% D)7.72% E)9.13%

What are the restaurant’s target capital structure weights?

A. 50% debt; 50% equity b. 60% debt / 40% equity c. 67%debt/ 33% equity d. 40%debt/60% equity E. 33%debt/67%equity What is the restaurant’s weighted average cost of capital? a. 11.04% b.7.82% c. 9.58% d.6.97% e.9.17% What is the restaurant’s enterprise value? a. $4,143,678 b. $5,398,701 c. $5,062,483 d. $5,740,779 e. $5,414,420

Answer 1

Year 1 Enterprise CF = Pre Tax CF * (1-tax rate) - Increase in WC - Increase in Capital Spending

Year 1 Pre Tax CF = 750000 * (1+2%) = 765000 ; Increase in WC = 60000 * (1+2%) = 61200 and Increase in Capital Spending = 75000 *(1+2%) = 76500

Year 1 Enterprise CF = 765000 *(1-35%) - 61200 - 76500 = 359550 hence option (D)

Year 2 Enterprise CF :

Year 2 Pre Tax CF = 765000 * (1+2%) = 780300 ; Increase in WC = 61200 * (1+2%) = 62424 and Increase in Capital Spending = 76500 *(1+2%) = 78030

Year 2 Enterprice CF = 780300 * (1-35%) - 62424 - 78030 = 366741; hence option (D)

COst of equity (as per CAPM) = 2.5% + 1.74 * 5.5% = 12.07%; hence option (B)

Target capital weight : given D/E = 0.67 or debt on equity is 2/3 which is option (d)

WACC = 40% * 9%*(1-35%) + 60% * 12.07% = 9.58% hence option (c)

We have Year 1 & Year 2 CF, we will calculate the Year 3 CF which is like terminal value calculation:

Year 3 Pre Tax CF Terminal Value = 780300/3% = 26010000; Increase in WC Termiinal Value = 62424/3% = 2080800 and Increase in Capital Spending Terminal Value = 78030/3% = 2601000

Enterprise CF Terminal Value at Year 3 = 26010000*(1-35%) - 2080800 - 2601000 = 12224700

Now Restaurant EV = Year 1 EV CF/(1+WACC) + Year 2 EV CF/(1+WACC)² + Year 3 EV Terminal Value CF/(1+WACC)³