In: Finance
Harry Carson is analyzing Tucson Corp., a manufacturing firm which follows US GAAP. He has gathered the financial information shown below in Exhibits 1, 2, and 3. Corporate income is taxed at a flat rate of 28%.
Exhibit 1: Tucson's current capital structure
Market Value (millions) |
Required return |
|
Bonds |
$500 |
4.0% |
Common stock |
$700 |
7.0% |
Total Capital |
$1,200 |
Exhibit 2: Selected financial data for Tucson (20X6)
(millions) |
|
Revenues |
$1,604 |
Depreciation expense |
$50 |
Interest expense |
$13 |
Fixed capital investment |
$80 |
Net income available to common shareholders |
$145 |
Exhibit 3: Selected balance sheet data for Tuscon
As of 31 December (in millions) |
20X6 |
20X5 |
Cash and cash equivalents |
$118 |
$105 |
Accounts receivable |
$265 |
$234 |
Inventories |
$589 |
$583 |
Total current assets |
$972 |
$922 |
Accounts payable |
$74 |
$63 |
Notes payables |
$70 |
$83 |
Other current liabilities |
$507 |
$506 |
Total current liabilities |
$651 |
$652 |
Carson then talks to his colleague, Mitchell Saunders, who
forecasts that Tuscon's net income will be $160 million in 20X7 and
that the following assumptions can be made for 20X7 and beyond:
Carson then asks another colleague, Wendy Pritchard, about the
proper method to value the firm. Pritchard makes the following
statements:
Statement 1: "Tucson pays dividends that are closely linked to its
capacity to pay dividends since its Board of Directors have
approved a constant dividend payout ratio policy. Therefore, free
cash flow methods are preferred. Dividend discount models are
invalid."
Statement 2: "Tucson’s capital structure seems unstable since it
might issue a large amount of long-term debt in the next couple of
years. Therefore, Tucson should use the FCFE method rather than the
FCFF method to value the company."
Statement 3: "The market consensus is that a private equity firm
intends to acquire a large share of Tucson stock to take control of
the company. Therefore, free cash flow measures are more
appropriate than dividend discount models."
Finally, while discussing alternative methods of computing free
cash flow with Pritchard, Carson makes the following comment: “We
must adjust for after-tax interest since interest paid is
considered an operating cash flow under US GAAP. Also, Tucson has
just announced that it will take more tax deductions than assumed
when reporting its deferred tax asset. Tucson would most accurately
estimate free cash flow by subtracting the deferred tax asset from
its free cash flows.”
Based on the information provided in Exhibit 1, please calculate Tucson’s weighted average cost of capital (WACC).
What is the value of free cash flow available to ALL of Tucson's capital providers in 20X6? (hint: FCFF)
Formula for Weighted Average Cost of Capital (WACC) is given as:
WACC = [Wd * Rd * (1 - t)] + [We * Re]
Where,
Wd = Percentage of Debt Capital in the Total Capital Structure
Rd = Cost of Debt Capital
t = Tax Rate
We = Percentage of Equity Capital in the Total Capital Structure
Re = Cost of Equity Capital
Given in the Question:
Wd = 500/1200 = 41.67 % = 0.4167
Rd = 4.00 % = 0.04
We = 700/1200 = 58.33 % = 0.5833
Re = 7.00 % = 0.07
t = 28.00 % = 0.28
WACC = [0.4167 * 0.04 * (1 - 0.28)] + [0.5833 * 0.07] = 5.28 % ................................ (Answer to Part I)
Now,
The Free Cash Flow available to all the capital providers is the Free Cash Flow to the Firm (FCFF)
Formula for FCFF is given as:
FCFF = EBIT * (1 - t) + Depreciation Expense - Capex - Change in Working Capital
(i) Calculation of EBIT (Earnings Before Interest & Taxes)
Net Income = Earnings after Tax = Earnings Before Tax * (1 - Tax Rate)
Rearranging in the above formula we will get;
Earnings Before Tax = Earnings After Tax/( 1 -Tax rate) = 145/(1- 0.28)
Here, earnings after tax = 145 Million $ ...................... (Given in the Question)
So, Earnings Before Tax = 201.39 Mn $
Then, EBIT = Earnings Before Tax + Interest Expense
EBIT = 201.39 + 13 = 214.39 Mn $ ............. (Interest Expense = 13 Mn $ ---- Given in the Question)
(ii) Depreciation = 50 Mn $ ..................... (Given in the Question)
(iii) Capex = Capital Expenditure = Investment in Fixed Capital = 80 Mn $ ....................... (Given in the Question)
(iv) Calculation of Change in Working Capital
Working Capital = Current Assets - Current Liabilities
Change in Working Capital = Working Capital in 2006 - Working Capital in 2005
For 2006
Current Assets = 972 ...................... (Given in the Question)
Current Liabilities = 651 ...................... (Given in the Question)
So, Working Capital = 972 - 651 = 321 Mn $
For 2005
Current Assets = 922 ...................... (Given in the Question)
Current Liabilities = 652 ...................... (Given in the Question)
So, Working Capital = 922 - 652 = 270 Mn $
Therefore, Change in Working Capital = 321 - 270 = 51 Mn $
So,
Free Cash Flow to the Firm (FCFF) = EBIT * (1 - t) + Depreciation Expense - Capex - Change in Working Capital
= 214.39 * (1 - 0.28) + 50 - 80 - 51
= 73.36 Mn $ ........................... (Answer to Part II)
Hopefully the solution will be helpful..