Question

Mr. Mwila, a research analyst, has been hired to value Le AVIC Ltd., a company that is currently experiencing rapid growth and expansion. Mwila is an expert in the construction industry and has had extensive experience in valuing similar firms. He is convinced that a value for the equity of Le AVIC Ltd. can be reliably obtained through the use of a three-stage free cash flow to equity (FCFE) model with declining growth in the second stage. Based on up-to-date financial statements, he has determined that the current FCFE per share is K2. He has prepared a forecast of expected growth rates in FCFE as follows: Stage 1: 9% for years 1 through 3 Stage 2: 6.0% in year 4, 4.5% in year 5, 4.0% in year 6 Stage 3: 3.0% in year 7 and thereafter Moreover, Mwila has determined that the company has a beta of 1.4. The current risk-free rate is 4.0%, and the equity risk premium is 7.0%. Other financial information: Outstanding shares: 200 kwacha shares. Tax rate: 35.0% Interest expense: K30 000.00.
Create a spreadsheet to calculate the following:
i. the required rate of return
ii. the terminal value in year 6
iii. The per share value Mwila assigned to Le AVIC ltd
iv. The free cash flow to firm (FCFF)

Answer 1

1. Required rate of return: As per the given information in the question the required return to be calculated using the Capital Asset Pricing Model(CAPM) whose formula is Rf+(Rm-Rf)Beta, Hint= Rm-Rf is a Rish premium.

So all information given in the question 4+(7)x1.4 = 4+9.8 = 13.8%

2. Terminal Value in Year 6 : We need to use Gordan growth formula to calculte here terminal value.

Gorgan growth formula =

P0 is Price today, D1 is Dividend at the end of year 1, Ke= Required rate of return, G= Growth

And we can Use FCFE(Free Cash flow to equity) here as Dividend because both represent the reidual part of profit after deducting all costs.

Question ask terminal value at te end of Year 6 so Rewriting the above formula as per question is

FCFE need here to calculate using growth rates given in question, compound the FCFE with rates.

Terminal Value at T6= 23.98

3) Per Value Share

Now calculate value of share by calculating the present Value of all future cash flows using Ke as required rate of return.

Calculation in Spreadsheet looks as:

Year	FCFE	PV Factor @ 13.8%	Present Value
1	2.0600	0.8787	1.8102
2	2.1218	0.7722	1.6384
3	2.1855	0.6785	1.4829
4	2.3166	0.5963	1.3813
5	2.4208	0.5239	1.2684
6	2.5177	0.4604	1.1592
6	23.9800	0.4604	11.0407
		Total	19.7810

So Value per share is 19.78.

4) Free Cash Flow to firm

Just look at the Finance sheet for calulation:

Earning Before Interest and Taxes ( EBIT)	xxx
Less: Interest	xxx
Earning before taxes	xxx
Less:Taxes	xxx
Earning avaible for Equity i.e. FCFE	xxx

We need to reverse calculate to reach EBIT which would be as Free Cash flow to Firm FCFF.

FCFE = 19.78 x 200( oustanding share) = 3956

Tax adjustment @ 35% , So 3956/(1-.35) , 3956/.65, = 6086.15 is earnings before taxes

Now add back the interest cost as given in question 30,000

So FCFF would be 6086.15+30000 = 36086.15.