Question

ABC Limited is a manufacturing company located in Nairobi County. The company manufactures and sells various products. You have been tasked with the assignment of estimating the value of operations for the firm using discounted cash flow approach. You have been provided with the following information for the company. (i) Data for ABC limited for the most recent period YEAR 2019

Revenues Sh. 30 Million

Operating Earnings Before Interest and Tax Sh. 9 Million

Fixed Capital Investment Sh. 4 Million

Working Capital Investment Sh. 2 Million

Depreciation Sh. 2 Million

ii) Corporate tax rate relevant for ABC limited is 30 %. The before tax cost of debt of ABC ltd. is 10 %

(iii)The average beta for ABC limited is 1.5 based on market value of debt and equity.

(iv)Average return on market and risk free rate of return is 12 % and 7 % respectively.

(v) The average debt equity ratio (based on market value of debt and equity) of ABC Limited is 0.25 (vi)The Free Cash Flow (FCF) of the company is expected to grow at annual rate of 5 % for ten years and 3 % each year thereafter forever.

Required:

(a) Compute Free cash flow to ABC limited for the most recent period ( Year 2019 )

(b) Compute after tax cost of debt

(c) Compute cost of equity using the Capital Asset Pricing Model (CAPM)

(d) Compute weighted average cost of Capital

(e) Compute Terminal value for ABC limited

(f) Compute the value of operations for ABC limited

Answer 1

Given,

Revenue = 30 million

Operating earnings before interest and tax

= 9 million

(a) Computation of free cash flows to ABC Ltd for year 2019

Particulars	Amount( in millions)
Operating earnings before interest and tax	9
Less: Corporate tax @30%(9×30%)	(2.7)
Earnings after tax(EBIT)	6.3
Less: Capital expenditure less Depreciation (4-2)	(2)
Less:Working Capital	(2)
Free cash flows(FCF)	2.3

(b) Computation of after tax cost of debt:

Before tax cost of debt = 10%

After tax cost of debt = 10×70% =7%

(c) Computation of cost of equity using CAPM method:

Given, Risk free rate of return (Rf).= 7%

Market rate of return (Rm) = 12%

Debt equity ratio = 0.25

β of equity = 1.5×75% = 1.125

Ke = Rf+β(Rm-Rf)

= 7+1.125(12-7)

= 12.625

(d) Computation of weighted average cost of capital:

weighted average cost of capital(WACC) = Cost of equity×weight of equity+After tax cost of debt×weight of debt

WACC = 12.625×75%+7×25%

= 11.219

(e) Terminal value for ABC Ltd:

Given, Free cash flows is expy to grow @ 5% for 10 years and @3% thereafter

Particulars	year 1 to 10	Terminal year
Free cash flows	2.3×5.836 =13.4228 [2.3×PVAF(11.219%,10)]	13.825 [13.4228+13.4228×3%]

Therefore Terminal Value = 13.825÷(0.11219-0.03)

= 13.825÷0.08219

= 168.208

(f) Computation of value of operations for ABC Limited:

Value of the firm = present value of free cash flows from year 1 to 10 + present value of Terminal cash flows

= 13.4228+168.208×PVF(11.219%,10)

= 13.4228+168.208×0.3453

= 71.505 millions