Question

18.5

Amarindo, Inc is a newly public firm with 8.0 million shares outstanding. You are doing a valuation analysis of AMR. You estimate its free cash flow in the coming year to be 15.05 million, and you expect the firms free cash flows only to grow by 4.4% per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of AMR's equity beta. However, you do have beta data for UAL, another firm in the same industry. AMR has a much lower debt-equity ratio of 0.33, which is expected to remain stable, and its debt is risk-free, AMR's corporate tax is 40%, the risk-free rate is 5.1% and the expected return on the market portfolio is 11.3%

Equity Beta Debt Beta Debt and Equity Ratio

UAL 1.65 .33 1.1

a. Estimate AMR's equity cost of capital.

b. Estimate AMR's share price.

Answer 1

	Step 1.
	We need to find the ungeared beta =betaU
	for UAL
	Geared beta of UAL =betaG=1.65
	Debt beta =betaD=0.33
	Debt Equity ratio=1.1:1
	so D/E=1.1/1
	Tax rate T=40%
	Now, ungeared beta=betaU=betaG*E/[E+D(1-T) + betaD*D(1-T)/[E+D(1-T)
	betaU=1.65*1.0/(1+1.1*0.6) +0.33*1.1(0.6)/(1+1.1*0.6))
	betaU=1.125
	So ungeared beta of the industry =1.125
	Step 2.
	We need to re-gear with the D/E ratio of AMR
	AMR details
	D/E=0.33/1
	Tax rate T=40%
	beta U=1.125
	beta D=beta of debt =0
	Noe geared beta=betaU+(betaU-betaD)*(1-T)*D/E
	Geared beta=1.125+1.125*0.6*0.33/1=1.35
	So the Equity beta for the AMR project =1.35

	Step 3.
	Finding Cost of Equity by CAPM
	Rf=Risk free rate =5.1%
	Rm=Required Market Return=11.3%
	Equity beta=1.35=Be
	Cost of Equity=Re=Rf+Be*(Rm-Rf)
	Re=5.1%+(11.3%-5.1%)*1.35
	Re=13.47%
Ans a.	So Cost of Equity =13.47%
	AMR Valuation
	Cost of Debt =5.1%
	Post Tax cost of debt=5.1%*(1-40%)=3.06%
	Cost of Capital= 13.47%*1/1.33 +3.06%*0.33/1.33 =	10.89%
	So the cost of Capital for AMR =10.89%
	Next year Cash flow $M	15.05
	Cash flow growth rate =g=	4.40%
	Cost of Capital =K	10.89%
	Firm Value one year later =15.05*(1+g)/(K-g)=15.05*1.044/(10.89%-4.4%)
	Firm Value after a year =$M	242.1
	Firm Value Now =242.10/1.1089=	218.32
	So Current Firm value $M=	218.32
	Assume the Equity Value =E
	Value of debt =0.33E
	so 1.33E=218.32
	E=164.15
	So Value of Total Equity in $M =	164.15
	No of shares outstanding in millio	8
Ans b.	Estimated price/share=164.15/8=	$            20.52