In: Finance
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 |
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.