Question

No Growth Incorporated had operating income before interest and taxes in 2011 of $225 million.The firm was expected to generate this level of operating income indefinitely. The firm had depreciation expense of $9.5 million that same year.Capital spending totaled $20 million during 2011. At the end of 2010 and 2011, working capital totaled $70 and $80 million, respectively.The firm’s combined marginal state, local, and federal tax rate was 30% and its debt outstanding had a market value of $1 billion.The 10-year Treasury bond rate is 6% and the borrowing rate for companies exhibiting levels of creditworthiness similar to No Growth is 7%.The historical risk premium for stocks over the risk free rate of return is 6%.No Growth’s beta was estimated to be 1.25.The firm had 2,000,000 common shares outstanding at the end of 2011. No Growth’s target debt to total capital ratio is 30%. (14 points)

Estimate free cash flow to the firm in 2011. Make sure to show your work.

Estimate the firm’s cost of capital. Make sure to show your work.

Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2011, assuming that it will generate the value of free cash flow estimated in (a) indefinitely. Make sure to show your work.

Estimate the value of the equity of the firm at the end of 2011. Make sure to show your work.

Estimate the value per share at the end of 2011. Make sure to show your work.

Answer 1

a.

Free Cash flow = EBIT × (1 - tax rate) + Deprecation - Capex - Change in working capital

= $225 × (1 - 30%) + $9.50 - $20.00 - ($80 - $70)

= $157.50 + $9.50 - $20.00 - $10

= $137 million.

Free Cash flow of companys is $137 million.

b.

Weight of debt = 70%

Weight of equity = 70%

Before tax cost of debt = 7%

After tax cost of debt = 7% × (1 - 30%)

= 4.90%

After tax cost of debt is 4.90%.

Cost of equity = 6% + (6% × 1.25)

= 6% + 7.50%

= 13.50%

Cost fo equity is 13.50%.

Now, Cost of capital that is WACC is calculated below:

WACC = (70% × 13.50%) + (30% × 4.90%)

= 9.45% + 1.47%

= 10.92%

WACC of company is 10.92%.

c.

Value of Firm = Free Cash flow / Cost of capital

= $137 / 10.92%

= $1,254.58 million.

Value of firm is $1,254.58 million.

d.

Value of equity = Value of firm - Value of debt

= $1,254.58 million - $1,000 million

= $254.58 million.

Value of total equity is $254.58 million.

Intrinsic value of equity = $254.58 / 2

= $127.29

Intrinsic value of equity is $127.29.