Question

Question 4. Cash Flow Valuation Model

A local investment banking firm, Denver Creek Inc., is evaluating a deal to acquire a sports apparel company, Breezee.

The company has a term loan requiring monthly payment and the principal of the loan to be paid down over the life of the loan (that is, amortized). The debt balance at year 0 is $150 million and the loan rate is 5% (APR or annual percentage rate =5%). The loan will mature at year 3 or in 36 months.

In the long term, the company plans to manage its capital structure to a target debt-to-value ratio. The target is set at the industry average level of 20%. When the term loan matures at the end of year 3, the company will refinance with new debt to reach the target level and will keep the debt ratio at 20% in the steady state (starting year 4).

The company’s capital structure over time is presented in the table below.

	Year 0	Year 1	Year 2	Year 3	Year 4
Debt-to-Value Ratio	80%	60%	40%	20%	20%
$ Debt ('mm)	150.0			40.0
Free Cash Flow to Firm (‘mm)		20	30	50

Other inputs and assumptions:
Unlevered cost of capital (Ru) = 9%; Cost of capital (Rwacc) in the steady state = 11% Tax rate = 21%; Long-term growth rate (LTg) = 2%

1. Determine the term loan’s monthly total payment, principle repayment and
interest payment, and construct the amortization schedule.
Note: An amortization schedule is a complete table of periodic loan payments, showing the amount of principal repayment and the amount of interest that comprise each payment until the loan is paid off at the end of its term. 


2. Choose the appropriate cash flow valuation model and explain your rationale.

3. Apply the model of your choice and estimate the target company’s value of operation. 


Answer 1

1..First, we need to find the equal mthly.pmt. For the 36 mths. At a mthly int. rate of 5%/12=0.004167 , using the pv of ordinary annuity formula,

150=Pmt.*(1-1.004167^-36)/0.004167

Solving the above, we get the mthly pmt. As

4.495662

Mlns.

With this, we can now draw the amortisation table

Fig.in mlns.
Mth.	Mthly.pmt.	Tow. Int.	Tow.Loan	Loan bal.
1	2	3=Prev.5*0.4167%	4=2-3	5=Prev.5-4
0				150
1	4.495662	0.62505	3.870612	146.1294
2	4.495662	0.608921	3.886741	142.2426
3	4.495662	0.592725	3.902937	138.3397
4	4.495662	0.576462	3.9192	134.4205
5	4.495662	0.56013	3.935532	130.485
6	4.495662	0.543731	3.951931	126.533
7	4.495662	0.527263	3.968399	122.5646
8	4.495662	0.510727	3.984935	118.5797
9	4.495662	0.494122	4.00154	114.5782
10	4.495662	0.477447	4.018215	110.56
11	4.495662	0.460703	4.034959	106.525
12	4.495662	0.44389	4.051772	102.4732
13	4.495662	0.427006	4.068656	98.40457
14	4.495662	0.410052	4.08561	94.31896
15	4.495662	0.393027	4.102635	90.21633
16	4.495662	0.375931	4.119731	86.0966
17	4.495662	0.358765	4.136897	81.9597
18	4.495662	0.341526	4.154136	77.80556
19	4.495662	0.324216	4.171446	73.63412
20	4.495662	0.306833	4.188829	69.44529
21	4.495662	0.289379	4.206283	65.239
22	4.495662	0.271851	4.223811	61.01519
23	4.495662	0.25425	4.241412	56.77378
24	4.495662	0.236576	4.259086	52.5147
25	4.495662	0.218829	4.276833	48.23786
26	4.495662	0.201007	4.294655	43.94321
27	4.495662	0.183111	4.312551	39.63066
28	4.495662	0.165141	4.330521	35.30014
29	4.495662	0.147096	4.348566	30.95157
30	4.495662	0.128975	4.366687	26.58488
31	4.495662	0.110779	4.384883	22.2
32	4.495662	0.092507	4.403155	17.79684
33	4.495662	0.074159	4.421503	13.37534
34	4.495662	0.055735	4.439927	8.935415
35	4.495662	0.037234	4.458428	4.476987
36	4.495662	0.018656	4.477006	-2E-05
	161.84383	11.84381	150

	Year 0	Year 1	Year 2	Year 3	Year 4
Debt		60%	40%	20%	20%
Equity		40%	60%	80%	80%
WACC		(60%*5%*(1-21%))+(40%*9%)=	(40%*5%*(1-21%))+(60%*9%)=	(20%*5%*(1-21%))+(80%*9%)=
		5.97%	6.98%	7.99%

	Year 0	Year 1	Year 2	Year 3	Year 4
Free Cash Flow to Firm (‘mm)		20	30	50
Horizon value of firm at end Yr.3
(50*1.02)/(11%-2%)				567
Total annual FCFF		20	30	617
So, PV of FCFFS=Value of Firm
(20/1.0597^1)+(30/1.0698^2)+(617/1.0799^3)=
535.016798
Millions
OR $ 535 millions