Question

Assume that we are now at the beginning of year 2020 and are trying to evaluate Company A using different valuation models. Answer all of questions below.   
1) The current leveraged beta of Company A is estimated to be 2.0 and the marginal tax rate is 40%. The risk-free rate for all the maturity is 3% and the market risk premium is 6.62%. Its debt-to-equity ratio is 1.00 currently. Next year, Company A expects to increase its debt-to-equity ratio to 1.50. Please calculate Company A’s current cost of equity, and estimate its cost of equity after it increases its debt-to-equity ratio.
2) Company A is facing a very competitive market condition and the projected free cash flow to the firm for the next five years are 500 million, 550 million, 600 million, 620 million, 650 million. Then it is expected to grow at a 3% beyond the fifth year. The WACC of the firm is estimated to be 10% and will not change in the future. Please use the “Perpetuity Growth Method” and estimate the firm’s enterprise value at the beginning of the year 2020(now).
3) The following table presents the EV/EBITDA information about Company A’s comparable companies.
Comparable Firm Information
Company Name EV/EBITDA
Company B 8.5 Company C 8.0 Company D 7.8
Besides, we also know that the EBITDA of Company A is 1500 million and its net debt is 6500 million. Its number of fully diluted shares is 100 million. Please estimate the firm’s share price range (+/- 1*standard deviation).

Answer 1

1)

Current scenario;

Levered beta=2

Risk free rate =Rf=3%

Market Rick Premium =Rm=6.62%

So cost of Equity =Re=Rf+beta*Rm

Re=3%+2*6.62%

Re=16.24%

So Current cost of Equity =16.24%

Now let us find unlevered beta in this case;

Unlevered beta =Levered Beta/[1+(1-T)*D/E]

Here T=40%

D/E=1

So Unlevered beta=2/[1+0.6]=2/1.6=1.25

Now let us find Levered beta when D/E=1.5/1

Levered Beta =Unlevered beta *[1+(1-T)*D/E]

Levered beta=1.25*[1+0.6*1.5]=2.375

So Levered Beta is 2.375 when D/E=1.5

So Cost of Equity =Re=Rf+beta*Rm

Re=3%+2.375*6.62%

Re=18.72%

So Cost of Equity when D/E =1.5 is 18.72%

ans 2		All amounts$Million
Details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Free cash flow to Firm		500	550	600	620	650
Terminal value at year 5 @3% perpetual growth =650*(1+g)/(Ke-g)=650*(1+3%)/(10%-3%), here WACC =Ke=10% growth rate =g=3%						9564.29
Total Free cash flow+ TV =		500	550	600	620	10,214
PV Factor @10% =1/1.1^n=	1.0000	0.9091	0.8264	0.7513	0.6830	0.6209
PV of FCFF+TV=		455	455	451	423	6,342
Sum of PV of FCFF+TV=	8,125.62
So Enterprise value now =$8,125.62 million