Question

The Chief Financial Officer (CFO) of the R70F Company is interested to identify the value of this company under multiple methods, for example, discounting dividend method using cost of equity or discounting cash flows using WACC. The company has 3 million shares, It has $70 million of debt at an interest rate of 5.2 per cent. The market believes that R70F can generate earnings of $12 million before interest and tax in perpetuity, and that R70F's beta coefficient is 1.4. R70F will pay out its available profits as dividends to its shareholders. Market risk premium is 4.2 per cent and govt bond yields 3.6 per cent. Tax rate is 31 per cent.

Requirement-a. Calculate cost equity and WACC for R70F.

Requirement-b. Calculate market value of R70F using suitable methods.

Requirement-c. briefly comment on the consistency or inconsistency you find between discounting dividend and discounting cash flows to derive equivalent values.

Requirement-d. briefly explain the impacts, if any, of business risk and financial risk of all-equity and leveraged firms on respective weighted average costs of capital.

Answer 1

PARTICULARS	AMOUNT
NUMBER OF SHARES	3000000
DEBT	70000000
INTEREST-5.20% OF DEBT	3640000
EARNINGS BEFORE INTERST AND TAX	12000000
INTEREST-5.20% OF DEBT	3640000
EARNINGS BEFORE TAX	8360000
TAX   @31% OF EBT	2591600
EARNINGS AFTER TAX	5768400
NUMBER OF SHARES	3000000
EPS	1.92
AS PER CAPM COST OF EQUITY CAPITAL	RF+BETA( RM-RF
RF	3.60%
RISK PREMIUM-RM-RF	4.20%
BETA	1.40
COST OF EQUITY	3.6+1.40*4.2	9.48%
VAUE OF FIRMS EQUITY
EARNINGS AFTER TAX/COST OF EQUITY CAPITAL	5768400/9.48%	60848101.27
NUMBER OF SHARES	3000000
VAUE PER SHARE		20.28
WACC			COST	WEIGHTS
SHARE CAPITAL		60848101.27	9.48%	0.465029	4.41%
DEBT		70000000.00	5.20%	0.534971	2.78%
		130848101.27
WACC					7.19%
The dividend discount model (DDM) is a quantitative method used for predicting the price of a
company's stock based on the theory that its present-day price is worth the sum
of its future dividend payments when discounted back to their present value.
Discounted cash flow (DCF) is a valuation method used to estimate the
value of an investment based on its future cash flows.
It shows how money generate in future.
If a firm is described as highly leveraged, the firm has more debt than equity
here the above example is related to more levered firm	46% equity and 54% debt
Leveraging existing assets to get exponentially more return can be a risk intensive
while a less-levered company may avoid bankruptcy due to higher liquidity.
A more levered firm can take tax advantage also