Question

Lockheed Corporation reported EBITDA of $4,000 million in the year just ended (year 0), prior to interest expenses of $1,000 million and depreciation charges of $600 million. Capital expenditures in the year just ended amounted to $1,000 million, and working capital was 8% of revenues (which was $20,000 million). The tax rate for the firm was 40%.

The firm had debt outstanding of $18.00 billion (in book value terms), trading at a market value of $20.0 billion and yield a pre-tax interest rate of 8%.

There were 100 million shares outstanding, trading at $250 per share, and the most recent beta was 1.20. The Treasury bond rate was 3%, and the market risk premium was 6.5%.

The firm expected revenues, earnings (EBITDA) and depreciation to grow at 10% a year from the current year (year 0) to year 3, after which the growth rate was expected to drop to 3% a year forever.

Capital expenditures will also grow at 10% a year from year 0 to year 3, but capital spending will be 120% of depreciation in the steady state period. The company also planned to lower its debt/equity ratio to 60% for the steady state which will result in the pretax interest rate dropping to 6%. As a result of the lowering of the firm’s debt/equity ratio, the beta of the firm is also expected to decline.

1. Estimate the free cash flow to the firm.

	Year 0	Year 1	Year 2	Year 3	Year 4
Growth Rate
EBITDA
Depreciation
EBIT
Taxes
EBIT(1-T)
Capital Expenditures
Revenues
Working Capital Required
Change in Working Capital
Free Cash Flow to Firm

2. Compute the beta of the firm after Year 3.

WACC Before Year 3 =

Cost of Equity After Year 3 =

WACC After Year 3 =

Answer 1

The free cashflows to the firm from year 1-4 are as given in the table below

	Figures in million $
	Year 0	Year 1	Year 2	Year 3	Year 4
Growth Rate		10%	10%	10%	3%
EBITDA	4000	4400	4840	5324	5483.72
Depreciation	600	660	726	798.6	822.558
EBIT	3400	3740	4114	4525.4	4661.162
Taxes	1360	1496	1645.6	1810.16	1864.465
EBIT(1-T)	2040	2244	2468.4	2715.24	2796.697
Capital Expenditures	1000	1100	1210	1331	987.0696
Revenues	20000	22000	24200	26620	27418.6
Working Capital Required	1600	1760	1936	2129.6	2193.488
Change in Working Capital		160	176	193.6	63.888
Free Cash Flow to Firm		984	1082.4	1190.6	1745.7

Currently ,

Market value of Debt = $20 billion

Market value of Equity = 100 million shares *$250 /share = $25 billion

Pre-tax Cost of Debt = 8%

Cost of equity = Riskfree rate+ beta * market risk premium = 3%+1.2*6.5% = 10.80%

So, WACC before year 3 = 20/(20+25)*8%*(1-0.4) + 25/(20+25)*10.80% = 8.1333%

After year 3,

D/E= 0.6

pretax cost of Debt =6%

Unlevered beta = 1.2/(1+(1-0.4)*20/25) = 0.810811

So, new levered beta = 0.810811* (1+(1-0.4)*0.6) = 1.102703

So, beta of the firm after year 3 = 1.102703

Cost of equity after year 3 = 3%+6.5%*1.102703 =10.16757%

So, WACC after year 3 = 0.6/1.6*6%*(1-0.4)+1/1.6*10.16757% = 7.7047%