Question

The following information for Arman Corporation is given at the beginning of the year. All figures are in million dollars

Sales = 250, Total capital = 200 million

Long-term Debt = 80 Cost of debt = 12 percent

Capital expenditures = 50 Assets = 200

Change in working capital = 19.25 Beta =1.5

Cost of goods sold = 100 Depreciation = 25

ROE = 15 % Tax rate = 35%

Risk-free rate = 5%

Administrative expenses = 10 Market risk premium = 8 %

Growth rate of the free cash flow = 50 % first year, 30 percent the following year, and then constant at 5% thereafter

Using the information, calculate the free cash flow and weighted average cost of capital (WACC) to find the value of this corporation at the beginning of the year

FCFF = EBIT (1-t) + Depreciation – Capital expenditures – Increase in NWC

FCFF₀ = (250-100-25-10)*0.65 +25-50-19.25 = 30.5

FCFF₁ = 30.5*(1.5) =45.75

FCFF₂ =45.75*(1.3) =59.475

WACC = (0.6)(5+1.5*8) +(0.4)*12*(1-0.35) = 13.32%

V1 = 59.475/(0.1332-0.05) =714.84375

Value today: V0 = (714.84375+45.75)/1.1332 = 671.191

Answer 1

NOTE: You have correctly calculated the WACC. You have done the following errors in solution-

1) while computing FCFF for year 0, you have not deducted Interest expense on long term debt @12%.

2) You have also done an error in PV Calculatipn.

I have solved the question completely below. In case of any doubt, feel free to ask.

CALCULATION OF FCFF for Year 1, 2 and 3

Particulars	Year 0
Sales	$250.00
Less: Cost of Goods sold	$100.00
Less: Depreciation	$25.00
Less: Administrative expense	$10.00
EBIT	$115.00
Less Interest (80 *12%)	$9.60
PBT	$105.40
Less: Tax@ 35%	$36.89
PAT	$78.11
Add: Depreciation	$25.00
Less: Capital Expense	$50.00
Less: Increase in working capital	$19.25
FCFF (Year 0)	$33.86

FCFF (Year 1) = $33.86 * 1.5 = $ 50.79

FCFF (Year 2) = $50.79 *1.3 = $66.027

FCFF (Year 3) = $66.027 * 1.05 = $69.328

CALCULATION OF WACC

WACC = Cost of equity * (MV of Equity / Total Financing) + Cost of Debt * (1-tax rate)* (MV of debt / Total Financing)

= [ (5+8*1.5) * ( 120 / 200 ) ] + [ 12 * ( 1 - 0.35 ) * ( 80 / 200 ) ]

=13.32%

CALCULATION OF VALUE OF FIRM USING PRESENT VALUE APPROACH

we are given that, Cash flow will continue to grow at the rate of 5% from 3 rd year onwards.

PV of perpetual cash flow in year 2 = $69.328 / ( 0.1332 - 0.05 )

= $833.27

Calculation of PV of all cash inflows-

Year	FCFF	PVF @13.32%	Present Value
1	$50.79	0.882	$44.82
2	$66.03	0.779	$51.42
2	$833.27	0.779	$648.89
		Value of company	$745.13

Thus value of company at the begining is $ 745.13

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