Question

You have the following information for Butterfly Inc.

US $million	2019	2018
Intangible assets	270	250
Property, plant and equipment	180	170
Inventory	120	120
Operating liabilities	180	150
Interest-bearing debt	125	125
Equity	265	265

US $million	2019
Sales revenue	200
Operating expenses	51
Depreciation & amortisation	30
Interest expense	9
Taxation	33
Profit for the year	77

The company has no interest income. Calculate the 2019 FCF (free cash flow) for Butterfly Inc.

c) Butterfly Inc’s interest bearing debt is a bond with a coupon of 6%, currently trading in the bond market at par (i.e. 100.00% of nominal value). At the end of 2019, its non-current assets have all been revalued to fair value, and the book value of its inventory also equals its fair value. Assume that the CAPM is an appropriate model for estimating the company’s cost of equity capital; and that

- Butterfly Inc’s tax rate is 30% and its equity beta is 0.8;

- the risk free rate is 2%, and the expected return on an appropriate stock market index 10%.

Calculate the market value of Butterfly Inc’s equity and its WACC (weighted average cost of capital).

d) Briefly explain why the market value of Butterfly Inc’s equity calculated in part (c) exceeds its book value.

e) Briefly outline the weaknesses of the CAPM model.

Answer 1

Amounts are in US$ millions

1.

Finding Capital Expenditure for 2019

= Balance of Tangible and intangible assets on 2019 end + Amortization and Depreciation - Balance of tangible and intangible assets on 2018 end

= (270+180) + 30 - (250+170)

= 60

Changes in Working capital

= Working capital on 2019 end - Working capital on 2018 end

= (120-180) - (120-150)

= -60 + 30

= -30

That means decrease in working capital, this will increase the cashflow

Free cash flow = EBIT (1-tax rate) + non cash expenditure - capital expenditure + decrease in working capital

= 110 (1-30%) + 30 - 60 + 30

= 83.3 + 30 - 60 + 30

= 83.3

Free Cashflow is taken for firm as a whole, so interest expense was not reduced

Note :

EBIT = 200 - 51 - 30 = 119

Tax rate = 33/110 = 30%

(2)

Using CAPM

Required return = Risk free return + Beta (Market rate of return - Risk free rate)

= 2% + 0.8(10% - 2%)

= 8.4%

Market value of equity = Profit/required rate of return

= 77/8.4%

= 916.67

(Using perpetuity earnings method)

WACC computation :

Weight of equity = 916.67/(125+916.67) = 88%

Weight of debt = 125/(125+916.67) = 12%

WACC = weight of equity x Cost of equity + weight of debt x Cost of debt

= 88% x 8.4% + 12% x 6%(1-30%)

= 7.392 + 0.504

= 7.896%

(3)

The market value of Equity is higher than the book value of equity because, the company is generating higher return than the epxected rate of return on its common stock (8.4%). We hve done valuation on earnings capacity method and not based on the Net assets valuation. The equity in books will show only the already earned profits along with common stock par value.

(4)

Weakness CAPM model

Some of its assumption are its main weakness

1. The risk free rate is taken from short term government bonds which fluctuates frequently

2. The market rate of return is taken by considering past return/ performance and not taking the future prospects

3. It assumes that all investors can borrow at risk free rate. But this is not possible practically

4. We cannot find the proxy beta for all the projects that are under consideration for decision making of a company.