Question

C4 A1 18

. In Europe the airlines and railway sectors are competing for the travel needs of the increasingly mobile and massive consumer market. TravelWithUs, a leading airline company is looking to create a new joint venture with FromHereToThere, Inc. a dominant player in the rapid transit railway sector that will provide a huge opportunity to create value through cost reductions in the excessive competition between the two sectors. This joint venture will also be able to provide new travel options to an increasingly demanding customer, combining air and travel routes, to minimize the time taken to travel between various destinations. The new joint venture will have an asset beta equal to 80% the sum of the asset beta of the airline and railway businesses. The joint venture would require a $20 billion investment and would generate after tax free cash flows of about $2.75 billion starting the following year (t = 1) and will grow at the rate of inflation of 3% for the foreseeable future. The joint venture would be financed by a $10 billion issuance of new stock each by TravelWithUs., Inc. and HereToThere, Inc. that will give each company a 50% ownership in the joint venture.

TravelWithUs., Inc. has a market value of equity of $50 billion and an industry average debt to equity ratio of 0.60. On the other hand, HereToThere, Inc. has a market value of equity of $25.00 billion and an industry average debt to equity ratio of 0.50. The airline business has an average beta of equity of 2.50, while the average equity beta in the railway business is 1.75. The average returns on debt in the airline and railway industries are 8.00% and 6.75%, respectively. 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. Assume that the tax rate is 34%, the interest payments on debt are tax deductible and the tax shield on debt is as risky as the assets of a business. What is the return on equity to the stockholders of TravelWithUs, Inc. after the formation of the joint venture? (No more than two decimals in the percentage but do not enter the % sign.)

I have worked out the following which have been confirmed to be correct:

New value = 92,481,089,258.70

New D/E = 48.01%

Answer 1

The Join Venture Generates after tax free cash flows (FCF) of $ 2.75 billion every year starting from year 1.

Now FCF or more popularly known as FCFF(Free Cash Flow to Firm) is calculated as given below:

FCFF = EBIT x (1 - Tax Rate) - Capital Expenditure + Depreciation - Changes in Net Working Capital

As Capital Expenditure, Depreciation and Changes in Net Working Capital is not mentioned we assume all of these figures to be zero.

This implies that FCFF = EBIT x (1 - Tax Rate)

EBIT = FCFF / (1 - Tax Rate) = 2.75 / (1 - 0.34) = $ 4.1667 billion

As the Joint Venture is Entirely Equity Financed EBIT = Net Income + Tax

Therefore, Net Income = 2.75 $ billion

Equity Contribution by each firm = 10 Billion $

Therefore, Joint Venture's ROE (Return on Equity) = (2.75 / 20) x 100 = 13.75%

As it is 50:50 JV the profits (net income) are eqully divided, which essentially implies that shareholder's of TravelwithUs Inc will also have an ROE of 13.75% after the JV formation.