Question

Chipotle expects to earn a free cash flow of $500 in 1 year; further, these cash flows are expected to grow at a rate of 3% forever. The discount rate on the burrito assets is 15%. Chipotle also has debt outstanding with a face value of $1000 and a maturity of 1 year, with an annual interest rate of 10% and a yield-to-maturity of 7%. After the debt matures in 1 year, Chipotle will not issue more debt. What is the value of Chipotle if its tax rate is 40%?

Answer 1

Find the below mentioned steps to compute the value of levered firm Chipotle as follows:

Step 1: Compute the value of unlevered firm as follows

Value of the unlevered firm = free cash flow next year / (Cost of capital - Perpetual growth rate)

Where,

Free cash flow next year = $500

Perpetual growth rate = 3%

Cost of capital or discount rate = 15%

Therefore,

Value of firm = $500 / (15% -3%)

= $500 / (0.15 -0.03) = $500 / 0.12

= $4166.67

So, the value of unlevered firm is $4166.67

Step 2: Compute the present value of interest tax shield as follows:

Present value of interest tax shield=(Annual interest payment*tax rate)/1+YTM

=($1000*10%)*40%/(1+7%)

=$40/1.07

=$37.38

Hence, the present value of interest tax shield is $37.88

Step 3: Compute the value of levered firm as follows:

Value of levered firm=Value of unlevered firm+present value of interest tax shield

=$4166.67+$37.38

=$4,204.05

Hence, the value of Chiptole is $4,202.05