Question

In: Finance

Below are a target's free cash flow projections and it's projections of interest expense from debt....

Below are a target's free cash flow projections and it's projections of interest expense from debt. The target's expect constant growth rate is 6%. It's unlevered cost of capital is 11.56%. The tax rate is 40%. Use this information to calculate 1) The unlevered value of the target 2) the value of the tax savings from interest expense and 3) the value of the target's operations.
tax rate 0.4
unlevered cost of capital 0.1156
constant growth rate for terminal cash flows 0.06
YEAR 0 1 2 3 4 5
FCF 11.7 10.5 16.5 20.7 21.94
interest expense 5 6.5 6.5 7 8.16

Solutions

Expert Solution

The solution is mentioned herewith with the use of excel.

1.

Unlevered cost of capital = 11.56%

Since the last year's projections must be at target capital with constant growth, the Unlevered horizontal value (with growth "g" of 6%) = FCF5 * (1+g) / {unlevered cost of capital - g}

= 21.94 * (1+0.06) / {0.1156 - 0.06) = $ 418.3

So, Unlevered horizontal value = $ 418.3

YEAR 1 2 3 4 5
FCF 11.7 10.5 16.5 20.7 21.94
Unlevered horizontal value (UHV) 418.3
Total (FCF+UHV) 11.7 10.5 16.5 20.7 440.24
Unlevered Value
[Total / (1+cost of capital)^no of years]
10.49 8.44 11.88 13.36 254.77

Hence, the total Unlevered value of the target = 10.49 + 8.44 + 11.88 + 13.36 + 254.77 = $ 298.94

2.

Similarly, Interest expense horizontal value = Interest expense5 * (1+g) / {unlevered cost of capital - g}

= 8.16 * (1.06) / (0.1156 - 0.06)

= $ 155.57

YEAR 1 2 3 4 5
Interest Expense (IE) 5 6.5 6.5 7 8.16
Interest expense horizontal value(IEHV) 155.5683
Total (IE+IEHV) 5 6.5 6.5 7 163.7283
Value of Tax saving from Interest
[Total / (1+cost of capital)^no of years]
4.48 5.22 4.68 4.52 94.75

So, Total value of Tax saving from Interest expense = 4.48 + 5.22 + 4.68 + 4.52 + 94.75 = $ 113.66

3.

The Value of Target's operation = Unlevered value + value of tax saving from interest expense

= 298.94 + 113.66 = $ 412.60

Hope this has solved your query.


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