Question

The following   information is given for a company.

	2002E	2003E	2004E	2005E	Terminal Value
EBIAT	50	50	60	60
CAPX	10	10	10	10
Depreciation	5	5	5	5
Investment in Working Capital	5	5	5	5
interest	5	5	5	5
goodwill	1	1	1	1

Risk free rate: 4%

Market risk premium: 7%

Expected growth rate of cash flows after 4.year = 5%

Beta Asset = 1.6

Beta Debt=1

Cost of Debt=8%

The company is planning to change the capital structure by the end of its 2^rd year. For the first two years debt to equity   ratio is 2/3 and 1/4 afterwards. Assume the cost of debt is decreased to 6% with the change in the debt of the company.   Calculate the value of the company using WACC approach. Assume corporate tax rate is 40%.

Answer 1

We will first find the WACC to discount the cash flows , in all the years

for which we need cost of equity

to apply CAPM, we need levered equity beat

Lev. Eq. beta=Asset beta(or UnL equity beta)*(1+(1-Tax rate)*D/E)

1.6*(1+((1-40%)*2/3))=

2.24

So,

As per CAPM,

Cost of equity=RFR+(Beta*MRP)

ie. 4%+(2.24*7%)=

19.68%

After-tax Cost of debt=8%(1-40%)=

4.8%

WACC=(Wt.d*kd)+(wt.e*ke)

(2/5*4.8%)+(3/5*19.68%)=

13.73%

So, WACC for the 1st 2 yrs.=13.73%

From Yr. 3 onwards, the capital structure changes to 1/4

so, first we will find the unlevered cost of equity , at the current debt level of 2/3 & then using that UnL cost of equity, using the same formula, find the levered cost of equity for debt level if 1/4

so, first we will find the unlevered cost of equity , at the current debt level of 2/3

using the formula,

Current lev.Cost of equity =UnL cost of equity+(D/E*(UnL ke-kd)*(1-Tax rate)

ie.19.68%=UnL ke+(2/3*(UnL ke-8%)*(1-40%))

Solving the above, we get the

UnL cost of equity= 16.34%

Now,

using the above UnL cost of equity, & using the same formula, find the levered cost of equity for debt level if 1/4

Current lev.Cost of equity =UnL cost of equity+(D/E*(UnL ke-kd)*(1-Tax rate)

Lev. Ke=16.34%+(1/4*(16.34%-8%)*(1-40%))=

17.59%

So, cost of equity at this level of debt= 17.59% &

After-tax Cost of debt=6%*(1-40%)=3.60%

WACC=(Wt.d*kd)+(wt.e*ke)

(1/5*3.60%)+(4/5*17.59%)=

14.79%

So, WACC for yrs. After 2 =14.79%

	2002E	2003E	2004E	2005E
EBIAT	50	50	60	60
Depreciation/Amortisation	-5	-5	-5	-5
EBIT	45	45	55	55
Tax at 40%	-18	-18	-22	-22
EAT	27	27	33	33
Add back: depn.	5	5	5	5
OCF	32	32	38	38
CAPX	-10	-10	-10	-10
Investment in Working Capital	-5	-5	-5	-5
Free cash flow	17	17	23	23
Terminal free cash flow(18*1.05)/(14.79%-5%)				193.054137
Total FCFs	17	17	23	216.054137
PV F at 13.73%(1/1.1373^yr.n)	0.87928	0.77313
PV F at 14.79% (1/1.1479^yr.n)			0.66113	0.57595
PVs of FCF s	14.94768	13.14313	15.20602	124.43609
Value of company	167.73293
	(Answer)