Question

2. Genoa Pasta manufactures Italian food products and currently earns $80 million in earnings before interest and taxes. You expect the firm's earnings to grow 20 percent a year for the next six years and 5% thereafter. The firm's current after- tax return on capital is 28%, but you expect it to be halved after the sixth year. If the cost of capital for the firm is expected to be 10% in perpetuity, estimate the terminal value for the firm. (The tax rate for the firm is 40%.)

Answer 1

Terminal Value can be calculated using the formula :

The growth rate in the above formula is assumed to be stable until perpetuity. Now since in the aabove case the growth rate is only 20% for the first six years and then stable beyond that at 5%. The EBIT value considered in case of the above question would be the terminal value at the end of the year after the sixth year i.e. at the end of seventh year.

Current EBIT (EBIT) is $80 million

Initial growth rate (g₁) = 20%

Susequent growth rate (g₂) = 5%

EBIT at the end of seventh year (EBIT₇ ) = 80 * (1.20)6 * (1.05) = $250.82 million

Tax rate (t) = 40% or 0.4

EBIT₇ (1-t) = 250.82 * ( 1 - 0.4) = 250.82 * 0.6 = $150.49 million

ROC beyond year 6 = 28/2 = 14%

Reinvestment rate in year 7 = Growth rate after year 6 / Return on Capital = g₂ / ROC = 5/14 = 35.71%

Thus terminal value, using the above formula:

Terminal value = 150.49 (1 - 0.3571) / (0.10 - 0.05) = $ 1935.00 million