Question

You have the following information about a company.

·       Sales in 2019 were £2000 million. Sales are expected to grow at a rate of 15% in 2020, and afterwards the growth rate will drop to 3%.

·       EBIT margin is expected to stay constant at 15%.

·       The corporate tax rate is 40%.

·       Net working capital each year is expected to stay constant at 10% of next year's sales.

·       To generate sales growth, each year t, capital expenditure net of depreciation (i.e., Capex- Depreciation) is expected to be 1/3 of the sales increase from year t to year t+1.

·       The debt-to-equity ratio (D/E) of the company is expected to stay constant at 1/2 and its equity cost of capital is 15%.

·       The firm has perpetual bonds outstanding with a coupon rate of 9% paid annually. The bonds are currently selling at par and have a AAA credit rating.

Question: Compute the value of the company at the beginning of 2020 using the WACC method. You may assume that all cash flows occur at the end of each year.

Answer 1

Sales in 2019 were £2000 million. Sales are expected to grow at a rate of 15% in 2020, and afterwards the growth rate will drop to 3%.

·       EBIT margin is expected to stay constant at 15%.

·       The corporate tax rate is 40%.

·       Net working capital each year is expected to stay constant at 10% of next year's sales.

·       To generate sales growth, each year t, capital expenditure net of depreciation (i.e., Capex- Depreciation) is expected to be 1/3 of the sales increase from year t to year t+1.

·       The debt-to-equity ratio (D/E) of the company is expected to stay constant at 1/2 and its equity cost of capital is 15%.

·       The firm has perpetual bonds outstanding with a coupon rate of 9% paid annually. The bonds are currently selling at par and have a AAA credit rating.

Question: Compute the value of the company at the beginning of 2020 using the WACC method. You may assume that all cash flows occur at the end of each year.

.

value of the company = PV of 2020 Free cash flow + Terminal value at end of 2020

First we need to calculate WACC

debt-to-equity ratio (D/E) of the company is expected to stay constant at 1/2

equity cost of capital is 15%

Cost of bond = 9% - 40% = 5.4%

WACC = ( ( 5.4% * 1 ) + ( 15% * 2 ) ) / 3

WACC = 35.4 / 3 = 11.8%

.

Free cash flow = EBIT - change in Net working capital - CAPEX - Dep

EBIT = EBIT margin is expected to stay constant at 15%

2020 sales = 2000 million + 15% = 2300 * 15% = 345 million

.

change in Net working capital = 2020 working capital - 2019 working capital

2020 working capital = 10% of 2021 sales

2021 sale = 2300 + 3% = 2369

2020 working capital = 2369 * 10% = 236.9

2019 working capital = 10% of 2020 sales = 2300 * 10% = 230

change in Net working capital = 236.9 - 230 = 6.9 million

.

CAPEX - Dep = capital expenditure net of depreciation (i.e., Capex- Depreciation) is expected to be 1/3 of the sales increase from year t to year t+1.

2019 sales = 2000 * 1 / 3 =      667 million

2020 sales = 2300 * 1 / 3 = 767 million

CAPEX - Dep = 767 - 667 = 100 million

.

Free cash flow in 2020= 345 - 6.9 - 100 = 238.1 million

Pv of Free cash flow in 2020 = 238.1 / ( 1+ 11.8% ) = 212.97 million

.

Terminal value at end of 2020 = FCF / (WACC - G )

FCF = 238.1 million

WACC = 11.8%

G = growth rate = 3%

.

Terminal value at end of 2020 = 238.1 / (11.8% - 3%)

Terminal value at end of 2020 = 238.1 / 8.8% = 2705.68 million

.

value of the company = 212.97 + 2705.68 = $2918.65 million