Question

You work at the equity research department of a large investment bank and your task is to determine the value of the company Example.com using the WACC method. You have the following estimates for Example.com’s yearly financials for the year 2018.

a. Net Income is £300 million.

b. The corporate tax rate is 25%.

c. The interest expense is £100 million. d. Depreciation is £150 million.

e. Capital expenditure is £200 million.

f.    Net working capital in December 2017 is equal to £350 million and net working capital in December

2018 is equal to £400 million.

g. Total unlevered free cash flows are expected to grow at a rate of 30% per year until December 2020, and then the growth rate will drop to 4% per year forever.

As Example.com is not public yet, you have to estimate its cost of capital using a comparable firm

Model.com. You have the following information for the comparable:

–    The debt-to-equity ratio (D/E) of Model.com is expected to remain constant at 0.5 and its debt beta is zero.

–    The equity beta of Model.com is 1.2.

Assume the CAPM relation holds for equity capital (not necessarily for debt), the risk-free rate is 4%, and the expected market risk premium is 6%.

The debt-to-equity ratio (D/E) of Example.com is expected to remain constant at 1, its debt beta is zero, and its (pre-tax) cost of debt is 4.8%.

a. Forecast the unlevered free cash flows of Example.com in 2019 and 2020.

b. Estimate the after-tax weighted average cost of capital (WACC) for Example.com. c. What is the enterprise value of Example.com at the beginning of 2019? You may

assume that all cash flows occur at the end of each year.

You work at the equity research department of a large investment bank and your task is to determine the value of the company Example.com using the WACC method. You have the following estimates for Example.com’s yearly financials for the year 2018.

a. Net Income is £300 million.

b. The corporate tax rate is 25%.

c. The interest expense is £100 million. d. Depreciation is £150 million.

e. Capital expenditure is £200 million.

f.    Net working capital in December 2017 is equal to £350 million and net working capital in December

2018 is equal to £400 million.

g. Total unlevered free cash flows are expected to grow at a rate of 30% per year until December 2020, and then the growth rate will drop to 4% per year forever.

As Example.com is not public yet, you have to estimate its cost of capital using a comparable firm

Model.com. You have the following information for the comparable:

–    The debt-to-equity ratio (D/E) of Model.com is expected to remain constant at 0.5 and its debt beta is zero.

–    The equity beta of Model.com is 1.2.

Assume the CAPM relation holds for equity capital (not necessarily for debt), the risk-free rate is 4%, and the expected market risk premium is 6%.

The debt-to-equity ratio (D/E) of Example.com is expected to remain constant at 1, its debt beta is zero, and its (pre-tax) cost of debt is 4.8%.

a. Forecast the unlevered free cash flows of Example.com in 2019 and 2020.

b. Estimate the after-tax weighted average cost of capital (WACC) for Example.com. c. What is the enterprise value of Example.com at the beginning of 2019? You may

assume that all cash flows occur at the end of each year.

Answer 1

Solution:

a)Calculation of Unlevered free cash flow for 2019 and 2020

Statement showing Unlevered free cash flow for 2018

	Amount(£)
Net Income	300,000,000
Add:Tax(300,000,000/0.75)*.25	100,000,000
Add:Interest	100,000,000
Earning before interest and Tax(EBIT)	500,000,000
Less:Tax	100,000,000
Add:Depreciation	150,000,000
Less:Capital expenditure	200,000,000
Less:Increase in Net working capital(400-350)	50,000,000
Unlevered Free Cash flow	300,000,000

Unlevered Free cash flow for 2019=Unlevered Free Cash flow for 2018(1+growth rate)

=300,000,000(1+0.30)

=£390,000,000 or £390 million

Unlevered Free cash flow for 2020=Unlevered Free Cash flow for 2019(1+growth rate)

=£390,000,000(1+0.30)

=£507,000,000 or £507 million

b)Calculation of after tax WACC

Asset Beta=Equity Beta/1+(1-tax rate)*D/E

Asset beta of Model.com

=1.2/1+(1-.25)*.50

=1.21/1.375=0.88

Asset beta for both company will be same.Thus Equity beta of Example.com is;

=Asset beta*[1+(1-tax rate)*D/E)]

=0.88[1+(1-0.25)*1]

=0.88*1.75=1.54

Thus,cost of equity of Example.com as per CAPM

=Risk free rate+Equity beta(market risk premium)

=4%+1.54(6%)

=13.24%

Weight of debt and equity in capital structre

Since D/E is 1,it means proportion of debt and equity is equal in capital structre.Therefor weight of debt(Wd) is 0.50 and Equity(We) is 0.50

WACC=Cost of equity*We+Cost of debt(1-tax rate)*Wd

=13.24%*0.50+4.8%(1-0.25)*0.50

=6.62%+1.80%=8.42%

Thus after tax WACC is 8.42%

c)Calculation of Enterprise value at the begining of 2019

Terminal value at the end of 2020=Unlevered FCF for 2021/(WACC-growth rate)

=£507,000,000(1+0.04)/8.42%-4%

=£11929,411,765

It is the present value of unlevered cash flow expected after 2018.Thus Enterprise value is calculated as follows

=£390,000,000/(1+0.0842)^1+£507,000,000/(1+0.0842)^2+£11929,411,765/(1+0.0842)^2

=£359,712,230+£431,309,629+£10148,461,849

=£10939,483,708 or £10939.49 million