Question

Garvezzi Vineyards is a large winery in Northeast Ohio, and it has been under new ownership for a couple of years now. The new owners are young entrepreneurs who want to expand the product line of wines by introducing wine cocktails, but the efforts have not been successful so far. The owners borrowed heavily from the local banks and currently the winery has a debt-to-equity ratio of 1. The lending experts at First State Bank of Ohio estimate that the winery will be able to maintain the current level of annual cash flows of 10.35 million dollars for the next three years at most. The interest expense for this year is 1.6 million and it will be increasing by 7 percent annually for the next three years. Experts expect that starting in year 4 both cash flows and interest expense will be decreasing by 3 percent a year forever. The combined federal and state tax rate is 24 percent. The unlevered equity cost is 14 percent. Apply the compressed APV approach to determine the value of operations of the winery today.

Answer 1

Annual Cash Flows = $ 10.35 million which remains constant for the next 3 years, Post Year 3 the Annual Cash Flows go down at a perpetual rate of 3%. Unlevered Cost of Capital = 14 %

Year 4 Cash Flow = 10.35 x (1-0.03) = $ 10.0395 million

Total Present Value of Annual Cash Flows = P1 = 10.35 x (1/0.14) x [1-{1/(1.14)^(3)}] + [10.0395 / (0.14+0.03)] x [1/(1.14)^(3)] = $ 63.8899 million ~ $ 63.89 million

Current Interest Expense = $ 1.6 million, 3-Year Growth Rate = 7 % and Tax Rate = 24 %

Interest Expense at the end of Year 4 = 1.6 x (1.07)^(3) x (0.97) = $ 1.90127 million

Total Present Value of Interest Tax Shield (Interest Expense x Tax Rate x Discount Factor) = P2 = [0.24 x 1.712] / (1.14) + [0.24 x 1.83814] / (1.14)^(2) + [1.96007 x 0.24] / (1.14)^(3) + [(1.90127 x 0.24) / (0.14+0.03)] x [1/(1.14)^(3)] = $ 2.82795 million

Value of Operations = P1 + P2 = 63.89 + 2.83 = $ 66.7179 million ~ $ 66.72 million