Question

Charles Jones seeks to evaluate the Reliant Home Furninshing company using a 3-tier growth model. He obtained the following information:
- Current Free Cash Flow (FCFF) = $ 755 million;
- Shares in circulation = 311 million;
- Equity Beta = 1.02; risk-free rate: 4.9%; risk premium (equity) = 5.11%;
- Cost of debt 7.1%;
- Marginal tax rate = 34%;
- Capital structure = 23% debt, 77% (equity);
- Long-term debt = 1.4 billion;
- FCFF growth rate =
8.1% per year for level 1, year 1-4;
7.3% for year 5, 5.9% for year 6, 4.5 for year 7 3.01% for year 8 and after.
From the information Jones has gathered, estimate:
1. The weighted average cost of capital (WACC), The total value of the firm, The total value of equity, Value per share and Give the definition of FCFF by explaining each of the components making it possible to obtain this value.

Answer 1

weighted average cost of capital (WACC) = weight of debt*cost of debt*(1-tax rate) + weight of equity*cost of equity

weight of debt is given as 23% and equity 77%.

cost of equity = risk-free rate + beta*risk premium = 4.9% + 1.02*5.11% = 4.9% + 5.2122% = 10.11%

weighted average cost of capital (WACC) = 0.23*7.1%*(1-0.34) + 0.77*10.11% = 0.23*7.1%*0.66 + 7.7847% = 1.07778% + 7.7847% = 8.86%

Terminal value is the present value of FCFF for year 8 and beyond. it is calculated at the end of year 7. so, it will be discounted for 7 years only.

Year	0	1	2	3	4	5	6	7	8
WACC		8.86%	8.86%	8.86%	8.86%	8.86%	8.86%	8.86%	8.86%
FCFF growth rate		8.10%	8.10%	8.10%	8.10%	7.30%	5.90%	4.50%	3.01%
FCFF	$755	$816.16	$882.26	$953.73	$1,030.98	$1,106.24	$1,171.51	$1,224.23	$1,261.08
Terminal value								$21,556.85
PV of FCFF & Terminal value		$749.73	$744.49	$739.30	$734.14	$723.62	$703.94	$12,574.65
Total value of firm (in million)	$16,969.86
Long-term debt (in million)	$1,400
Total value of equity	$15,569.86
no. of shares outstanding	311
Value per share	$50.06

Calculations

FCFF = Net operating profit after taxes + Depreciation - Capital expenditure - changes in working capital

Net operating profit after taxes = operating profit - taxes

Operating profit = Sales - Cost of goods sold - Salaries and wages - Depreciation - selling, general & administrative expenses - Other operating expenses

Capital expenditure = net fixed assets or Plant, Property and Equipment of current year - net fixed assets or Plant, Property and Equipment of previous year + Depreciation current year

changes in working capital = net working capital of current year - net working capital of previous year

net working capital = Current assets - Current liabilities

Current assets = Accounts receivable + Inventory + Prepaid expenses

cash will not be considered in Current assets for FCFF calculation.

Current liabilities = Accounts payable + Salaries payable + interest payable + Income tax payable + other accrued liabilities