Question

For a company, the cash flow from assests (or free cash flow) projections for the next three years are as follows. After year 3, the company will continue growing at a constant rate of 1.5%. the firm's tax rate is 3% and will maintain a debt-equity ratio of 0.50. the risk-free rate is 3%, the expected market risk premium over the risk free rate is 6%, and the company's equity beta is 1.50. The company's pre-tax cost of debt is 7.5%.

free cash flow
year 1: $15,000
year 2: $20,000
Year 3: $22,000

1. what is cost of equity? (4 decimal places)
2. what is WACC? (4 decimals)
3. compute the FCF in year 3 (no decimals)
4. compute enterprise value of company. (no decimals)
5. If the company has net debt of $50,000, would you buy the equity for $100,000 dollars? (yes or no)

Answer 1

Question 1:

Risk free rate = Rf = 3%

Market Risk Premium = (Rm-Rf) = 6%

Equity Beta = 1.50

Cost of equity = Rf + Beta * (Rm-Rf)

= 3% + 1.50 * 6%

= 3% + 9%

= 12%

Cost of Equity is 12%

Question 2:

Cost of equity = re = 12%

pre tax cost of debt = rd = 7.5%

t = tax rate = 3%

debt + equity = 1

debt / equity = 0.5

debt = 0.5 equity

debt = 0.5 (1- debt)

1.5 debt = 0.5

debt =Wd = 0.33333

equity = We = 0.66667

Weighted Average Cost of Capital = [Wd * rd* (1-t)] + [We * re]

= [0.33333* 7.5% * (1-3%)] + [0.66667 * 12%]

= 2.42497575% + 8%

= 10.42%

Therefore, WACC is 10.42%

Question c:

r = WACC = 10.42%

g = growth rate = 1.5%

FCF in Year 4 = FCF in Year 3 * (1+g) = $22,000 * (1+1.5%) = $22,330

Horizon value = FCF in Year 4 /(r-g)

= $22,330 / (10.42% - 1.5%)

= $250,336.32287

FCF in Year 3 = FCF in Year 3 + Horizon Value

= $250,336.32287 + $22,000

= $272,336.32287

Question 4:

Enterprice value of company = [FCF in Year 1/ (1+r)^1] + [FCF in Year 2/ (1+r)^2] + [FCF in Year 3/ (1+r)^3]

= [$15,000 / (1+10.42%)^1] + [$20,000 / (1+10.42%)^2] + [$272,336.32287 / (1+10.42%)^3]

= [$15,000 / 1.1042] + [$20,000 / 1.21925764] + [$272,336.32287 / 1.3463042861]

= $13,584.495562 + $16,403.423972 + $202,284.37633

= $232,272.29586

Enterprise value of the company is $232,272.30

Question 5:

Debt value = $50,000

Equity value of the company = Enterprice value - Debt value

= $232,272.30 - $50,000

= $182,272.30

Equity value of the company more than purchase price. Hence we will buy equity for $100,000