Question

Jaime Corporation reported net income of $60 million for last year. Depreciation expense totaled $20 million and capital expenditures came to $5 million. Free cash flow is expected to grow at a rate of 6% for the foreseeable future. Lambert faces a 30 % tax rate and has a 0.40 debt to equity ratio with $200 million (market value) in debt outstanding. Lambert's equity beta is 1.20, the risk free rate is currently 4% and the market risk premium is estimated to be 7%. What is the current total value of Jaime Corporation's equity (in millions)? Pick the closest answer.

a) $1742.47

b) $1542.47

c) $935.10

d) $951.26

e) $735.10

Answer 1

Let Current Time be t=0

At t= 0, the firm has following details

Free Cash Flow to Firm (FCFF0) = Net Income + Depreciation - Capital Expenditures = 60 + 20 - 5 = $ 75 million

The FCFF is expected to grow perpetually at 6% per annum. Therefore, to value the firm one needs to discount the perpetually growing FCFF using Gordon's growth formula and firm's WACC.

Debt Equity Ratio = D/E = 0.4

Therefore, E/V = (1/1.4) and (D/V) = (0.4/1.4) where V = D+E

Also, Risk Free Rate =4% =Rf and Market Risk Premium =Rm = 7% and Equity beta = 1.2

Therefore, Cost of Equity = R(e) = Rf + Equity Beta x R(m) = 4 + 1.2 x 7 = 12.4%

As debt is considered to be default free (risk free) in most cases, the cost of debt = risk free rate = R(d) =4%

Tax Rate = t = 30%

Therefore, Firm's Cost of Capital R(c) = R(d) x (1 - t) x (D/V) + R(e) x (E/V) = 4 x 0.3 x (0.4/1.4) + 12.4 x (1/1.4) = 9.6571 %

Using Gordon's Growth Formula to calculate firm value at present

Firm Value = V =[FCFF0 x (1+growth rate)]/[R(c) - growth rate)] = (75 x 1.06) / (0.096571 - 0.06) = $ 2173.8536 million

Existing Capital structure has E/V as (5/7)

Hence, Current Equity Value = (5/7) x V = (5/7) x 2173.8536 = $ 1552.75 million which is closest to option (b) $ 1542.47

Hence, correct answer is option (b).