In: Finance
The MoMi Corporation’s cash flow from operations before interest
and taxes was $3.3 million in the year just ended, and it expects
that this will grow by 5% per year forever. To make this happen,
the firm will have to invest an amount equal to 15% of pretax cash
flow each year. The tax rate is 21%. Depreciation was $390,000 in
the year just ended and is expected to grow at the same rate as the
operating cash flow. The appropriate market capitalization rate for
the unleveraged cash flow is 14% per year, and the firm currently
has debt of $6 million outstanding. Use the free cash flow approach
to calculate the value of the firm and the firm’s equity.
(Enter your answer in dollars not in
millions.)
Value of the firm ?
Value of the firm's equity ?
Solution: | ||||
Value of the firm | $25,595,500 | |||
Value of the firm's equity | $19,595,500 | |||
Working Notes: | ||||
Notes: | First of all we Free cash flow which we get '= Earnings After taxes + Depreciation - Investment | |||
Then free cash flow will be used to get value of the firm Gordon method with constant growth rate. And at last value of equity by reducing value of debt from value of the firm. | ||||
Computation of value of the firm | ||||
Earnings before interest, taxes & depreciation | $3,465,000 | A | ||
[$3,300,000 x (1.05)] | ||||
Less: | Depreciation | $409,500 | B | |
[$390,000 x (1.05)] | ||||
Taxable Income | $3,055,500 | C=A-B | ||
Less: | Taxes @ 21% | $641,655 | D | |
[$3,055,500 x 21% ] | ||||
Earnings( unleveraged) After-tax | $2,413,845 | E=C-D | ||
After-tax cash flow from operations | $2,823,345 | F=E + B | ||
[Earnings( unleveraged) After-tax + Depreciation ] | ||||
[$2,413,845+$409,500] | ||||
Now | ||||
New investment (15% of cash flow from operations the EBIT) | $519,750 | G= A x 15% | ||
[15% x $3,465,000] | ||||
Free Cash Flow | $2,303,595 | H=F- G | ||
[After-tax cash flow from operations - New investment] | ||||
[$2,823,345- $519,750] | ||||
Firm value = Free cash flow/(Unlevered capitalization rate - growth rate) | ||||
=$2,303,595/(0.14 - 0.05) | ||||
=$25,595,500 | ||||
Value of the firm's equity = Value of firm - Value of debt outstanding | ||||
=$25,595,500 - $6,000,000 | ||||
=$19,595,500 | ||||
Please feel free to ask if anything about above solution in comment section of the question. |