Question

Question:

(a) Calculate the free cash flow generated by a firm which has earnings before interest and taxes of £30m, has depreciated its fixed assets by £1m, has invested £10m in new fixed assets and £5m in working capital during 2019 when it paid corporate tax at 20%. Explain what you have assumed about the firm’s asset base.

(b) During 2019 the firm in (a) generated revenue of £60m, its cost of goods sold was £20m and its selling, general and administrative costs were £10m. You anticipate that over the next five years revenue will grow at 5% each year, the cost of goods sold will continue to be a fixed percentage of revenue, but due to managerial efficiencies administrative costs will not change. All forms of investment, together with depreciation will have a consistent relationship with revenue. At the end of this five-year period you believe that free cash flow will grow at 2% each year. What is the company worth at the end of 2019, assuming that its weighted average cost of capital is 5%?

(c) How would the company’s weighted average cost of capital and hence value change if it were to issue additional debt in order to repurchase equity?

(d) Explain how you could value this company using multiples, and what assumptions you would have to make.

Answer 1

a. Free cash flows
	Millions
EBIT	30
Less:Tax at 20%	6
NOPAT	24
Add back: depn.	1
Operating cash flow	25
Less: Capital expenditure in assets	10
Less: Inv. In working capital	5
Free cash flow	10
In this FCF valuation method,we assume that the cost of maintaining this asset base is taken care of ,by the operating cash flows--- before meeting debt interest costs.

b.                                              Fig.in millions	2019	2020	2021	2022	2023	2024
Year	0	1	2	3	4	5
1.Sales Revenues	60	63	66.15	69.4575	72.93038	76.57689
2.Cost of goods sold(20/60* revenues)	-20	-21	-22.05	-23.1525	-24.3101	-25.5256
3.S,G&A costs	-10	-10	-10	-10	-10	-10
4. EBIT(sum 1 to 3)	30	32	34.1	36.305	38.62025	41.05126
5.Tax at 20%(4*20%)	-6	-6.4	-6.82	-7.261	-7.72405	-8.21025
6. NOPAT(4+5)	24	25.6	27.28	29.044	30.8962	32.84101
7.Add back: Depn.(1/60*Sales revenues)	1	1.05	1.1025	1.157625	1.215506	1.276282
8. Operating cash flows(6+7)	25	26.65	28.3825	30.20163	32.11171	34.11729
9.CAPEX(10/60*Sales revenues)	10	10.5	11.025	11.57625	12.15506	12.76282
10.Change in CAPEX(Previous-Current)	-10	-0.5	-0.525	-0.55125	-0.57881	-0.60775
11.Working capital(5/60*Sales Revenues)	5	5.25	5.5125	5.788125	6.077531	6.381408
12.Change in NWC(Prev.-Current)	-5	-0.25	-0.2625	-0.27563	-0.28941	-0.30388
13. FCFs(8+10+12)	10	25.9	27.595	29.37475	31.24349	33.20566
14.Terminal FCF(33.20566*1.02)/(5%-2%)						1128.992
15.Total FCFS(13+14)		25.9	27.595	29.37475	31.24349	1162.198
16. PV F at 5%(1/1.05^ yr.n)		0.95238	0.90703	0.86384	0.82270	0.78353
17. PV at 5%(15*16)		24.66667	25.02948	25.37501	25.70409	910.6126
18.NPV/Company's worth at the end of 2019(sum of row 17)	1011.387877	millions

(c) How would the company’s weighted average cost of capital and hence value change if it were to issue additional debt in order to repurchase equity?

c. If the company were to issue additional debt & repurchase equity, that portion of debt with lesser after-tax cost , will weigh down the total cost of capital,ie. Weighted average cost of capital . The more costlier equity will be replaced by the less costly debt & the WACC will come down. So, cash flows discounted at lower WACC rates will push up teh total value of the company. The value will increase.

(d) Explain how you could value this company using multiples, and what assumptions you would have to make.

The main assumption is the ratio prevalent among comparable companies or in the industry--for example, EBITDA multiple of 5*X, or Enterprise value/ sales ratio or price/earnings ratio

The terminal value is then calculated by applying that chosen multiple like EV/EBITDA, EV/EBIT, EV/ sales , etc. to the figure (for EBITDA or EBIT or Sales ) forecasted for the last year , we are working with.That is, on figure of the fraction & the mutiple we know. We need to find the EV.

here, if we assume to adopt EV/ EBIT multiple of 6X in the terminal year, then the Enterprise value at end yr. 5 will be

33.20566*6= 199.234 millions. All the other workings are the same as for FCF method of valuation