Question

Please use the following information to answer Question 1-3

You are trying to value LF, a data processing company. The company generated $1 billion in revenues in the most recent financial year and expects revenues to grow 3% per year in perpetuity. It generated $30 million in after-tax operating income in the most recent financial year and expects after-tax operating margin to increase 1% per year starting from the current year (Year 0) to year 3. After year 3, the margin will stabilize at year 3 levels forever. The firm is expected to have depreciation of $ 20 million and capital expenditures of $15 million each year for the next 3 years and to earn a 10% return on capital in perpetuity after that. There are no working capital requirements. The cost of capital will be 12% for the next 3 years and 10% thereafter.

(Hint, we are currently in Year 0 and the After Tax Operating Margin in Year 0 is 3%)

1.Estimate the value of the firm at the end of the third year (terminal value).

2.Estimate the Present Value of the Terminal Value.

3.Estimate the value of equity per share today, if the firm has $150 million in debt outstanding, $25 million as a cash balance and 10 million shares.

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J	K
2
3		First free cash flow needs to be calculated using the following formula:
4		Free Cash Flow = EBIT*(1-T)+Depreciation & Amortization - Capex - Change in working capital
5
6		Year	0	1	2	3	4	5	…
7		Revenue	1000000000	=D7*(1+E8)	=E7*(1+F8)	=F7*(1+G8)	=G7*(1+H8)	=H7*(1+I8)	=I7*(1+J8)
8		Growth Rate		0.03	0.03	0.03	0.03	0.03	0.03
9		After Tax Operating Margin	0.03	=D9+1%	=E9+1%	=F9+1%	=G9	=H9	=I9
10		After Tax Operating Income	=D7*D9	=E7*E9	=F7*F9	=G7*G9	=H7*H9	=I7*I9	=J7*J9
11		Depreciation		20000000	20000000	20000000
12		Capital Expenditure		15000000	15000000	15000000
13		Free Cash Flow		=E10+E11-E12	=F10+F11-F12	=G10+G11-G12	=H10+H11-H12	=I10+I11-I12	=J10+J11-J12
14
15		1)
16
17		Calculation of Terminal Value:
18
19		Year	0	1	2	3	4	5	…
20		Free Cash Flow (FCF)		=E13	=F13	=G13	=H13	=I13	=J13
21		FCF Growth			=F20/E20-1	=G20/F20-1	=H20/G20-1	=I20/H20-1	=J20/I20-1
22		Cost of Capital		0.12	0.12	0.12	0.1	0.1	0.1
23
24		Since terminal growth rate starts at year 4, value of terminal cash flow at the end of year 3 can be calculated as follows:
25		Terminal cash flow in year 3	=FCF4/(w-g)
26			=H20/(H22-I21)	=H20/(H22-I21)
27
28		Hence Terminal Value at Year 3 is	=D26
29
30		2)
31		Since cost of capital is contant at 12% during the first 3 years then,
32		Present Value of Terminal Value	=D26/((1+E22)^3)
33
34		3)
35
36		Value of the firm can be calculated as follows:
37
38		Year	0	1	2	3
39		Free Cash Flow (FCF)		=E20	=F20	=G20
40		Cost of Capital		0.12	0.12	0.12
41		Terminal Value				=D26
42		Present Value of Cash flows		=E39/((1+E40)^E38)	=F39/((1+F40)^F38)	=(G39+G41)/((1+G40)^G38)	=(G39+G41)/((1+G40)^G38)
43		Value of the firm	=SUM(E42:G42)	=SUM(E42:G42)
44
45		Value of Equity can be calculated as follows:
46		Value of the firm	=D43
47		Debt	150000000
48		Cash	25000000
49		Value of Equity	=D46-D47-D48	=D46-D47-D48
50
51		Number of shares	10000000
52
53		Value of equity per share	=Value of equity / Number of shares
54			=D49/D51	=D49/D51
55
56		Hence Value of equity per share	=D54
57