Question

A firm has generated $150 million in earnings before interest and taxes last year and expects these earnings to grow 10% a year for the next 3 years. The firm is expected to generate a return on capital of 20% on new investments for the next 3 years, and there is no efficiency growth. After year 3, the firm will be in stable growth, growing 3% a year in perpetuity, with a return on capital of 12% and a cost of capital of 10%. The corporate tax rate is 30%. Estimate the terminal value of the company at the end of year 3

Answer 1

Reinvestment Rate after 03 Years of Operation =  growth rate/return on capital

growth rate after 03 Years = 3%

return on capital after 03 Years =12%

Reinvestment Rate after 03 Years of Operation = 3% / 12% = 0.03 / 0.12 = 0.25

Earning in Year 0 =  $150 million

Growth Rate of earning till year 03 =  10%

Earning in year 03 =  Earning in Year 0 * ( 1 + growth rate)^Year

= 150 * ( 1 + 10%) ^03

= $ 199.65 Million

Growth Rate after Year 03 = 3%

Earning in year 04 = Earning in year 03 *( 1 + growth rate) = 199.65 * ( 1 + 3%) = 205.6395

Now FCFE in Year 04 = Earning in year 04 * ( 1 - Tax Rate)

= 205.6395 * ( 1 - 30%)

= 143.94765

Terminal Value of the Firm at Year 03

cost of capital of 10% = 0.10

Growth Rate after Year 03 = 3% = 0.03

Terminal Value of the Firm at Year 03

= 107.96 / 0.07

= 1542.29

terminal value of the company at the end of year 3 =  $ 1542.29 Million (Ans)