Question

C4 A3 9 – 10

. You have been asked to value on of the biggest global companies, Malicaca, Inc., but using only the information provided to you (modified to camouflage the real identity of the company). Malicaca, Inc. is expected to have revenues of $500 million next year (t = 1) that are expected to grow at 8% per year thereafter for the foreseeable future. The data presented to you shows that COGS and SGA are expected to remain at 50% and 10% of revenues for the foreseeable future. For simplicity, you are also asked to make the following assumptions: (a) depreciation is 15% of revenues; (b) it is safe to assume that capital expenditures will be approximately equal to depreciation; and, (c) Malicaca, Inc. will be able to manage with no changes in working capital.

You are also provided some detailed information about the Malicaca, Inc.’s main competitors and some market data. The business competitors have an average beta of equity of 2.50, and an average debt/equity ratio of 35% with an average beta of debt of 0.25. The risk free rate is 2.50% and the expected market risk premium (the difference between the market return and the risk free rate) is 4.00% for the foreseeable future. The tax rate is 34%. Assume that the interest payments on debt are tax deductible and for the industry/comparables the tax shield on debt is as risky as the assets of a business.

Malicaca, Inc. is contemplating taking on a reasonably aggressive debt strategy, but comparing and evaluating two dramatically different debt structures. Debt STRUCTURE A involves taking on $1.50 billion of debt today (t = 0) and buying back an equivalent dollar amount of shares. Concerned about this level of debt the management will keep it constant for the foreseeable future, in spite of the strong estimated growth in free cash flows of 8% per year. Assume that the interest payments on debt are tax deductible. With a fixed level of debt, it is reasonable to assume that the tax shield on debt is as risky as the debt of Malicaca, Inc. The return on debt is 5% per year

9. Given this information, which valuation method is most suited for this capital structure policy? Explain why

a) Adjusted Present Value (APV) Method

b) Enterprise Value (WACC) Method

c) Equity Valuation Method

10. The value of Malicaca, Inc. will increase to?

Answer 1

(9) The company is assumed to be initially debt free prior to t=0. Post that the management decided to raise a debt of $ 1.5 Billion and subsequently use the proceeds to repurchase an equivalent amount of dollar shares. As it is concerned about debt levels spiralling out of control , it proposes to keep the debt level constant post that. This ensures that the company's Debt to Equity Ratio, Debt to Value Ratio and Equity to Value Ratios remains constant going forward. In such a scenario using the Enterprise Method of Valuation using company WACC at the fixed Debt to Equity Ratio is the most apporpriate method. APV is generally used when debt levels are sporadic in scenarios such as a leveraged buyout, highly leverage project financing, highly leveraged capital expenditure, etc. This makes sense because a varying debt level leads to a varying WACC, which is inapporpriate for usage. APV on the other hand separately values the company operating assets as a purely equity financed entity followed by adding the value generated by Tax Shields (interest and depreciation mainly) to the value of operating assets.

Equity Valuation Method is also inapporpriate as this method concerns itself with calculating the value of only a company's equity component. This would have been an appropriate method had the company been entirely equity financed like before which is no longer the case.

NOTE: Please state question 10, in more clear terms for solution to the same. Clearer in the context of describing the circumstances under which Malicaca Inc's value is expected to increase. Scenario Analysis of the stated circumstances will be used to determine the increased firm value.