Question

RMA is a public firm with 11.5 million shares outstanding. You are doing a valuation analysis of RMA. You estimate its free cash flow in the coming year to be $15.46 million, and you expect the firm's free cash flows to grow by 7.1% per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of RMA's equity beta. However, you do have beta data for LAU, a comparable firm in the same industry:

Equity Beta    Debt Beta    Debt-Equity Ratio

LAU    2.05    0.33    1.1

RMA has a much lower debt-equity ratio of 0.33, which is expected to remain stable, and its debt is risk free. RMA's corporate tax rate is 32%, the risk-free rate is 5.2%, and the expected return on the market portfolio is 11.5%.

a. Estimate RMA's cost of equity.

b. Find WACC

c. Find value of RMA using WACC method

d. Estimate RMA's share price

Answer 1

calculating unlevered beta using comparable firm data

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

2.05 = Unlevered Beta*(1+((1-0.32)*(1.1)))

Unlevered Beta = 1.17

calculating levered beta for RMA

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 1.17*(1+((1-0.32)*(0.33)))

levered beta = 1.43

a.

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 5.2 + 1.43 * (11.5 - 5.2)

Expected return% = 14.21

b.

D/A = D/(E+D)

D/A = 0.33/(1+0.33)

'=0.2481

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.2*(1-0.32)

'= 3.536

Weight of equity = 1-D/A

Weight of equity = 1-0.2481

W(E)=0.7519

Weight of debt = D/A

Weight of debt = 0.2481

W(D)=0.2481

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=3.54*0.2481+14.21*0.7519

WACC% = 11.56

c.

company value= FCF in 1 year/(WACC - growth rate)

= 15.46/ (0.1156 - 0.071)

= 346.64 usd mln

d

share price = company value /shares outstanding = 346.64/11.5 = 30.142