Question

The Mason Corporation’s income before interest, depreciation, and taxes (i.e., EBITDA) was $2.05 million in the year just ended. The firm expects its EBITDA to grow by 2.3% per year forever. To make this happen, the firm will have to invest in plants and equipments an amount equal to 24% of its pre tax operating cash flow (i.e., EBITDA) each year. The tax rate is 30%, depreciation in the year just ended was $233,500, and is expected to grow at the same rate as EBITDA. The firm expects to maintain a constant level of net working capital. The firm has $4.9 million in debt outstanding.

A.) Estimate the FCFF for the coming year

B.) An analyst tries to value the firm and calculates the interest coverage ratio, and finds that the ratio correspond to a default spread of 5.5%. The risk free rate is 2%. What is Mason’s cost of debt?

C.) The beta of Mason Corp. is .96, and the market risk premium is currently 6.9%. What is Mason’s cost of equity?

D.) In the year just ended, the capital structure of the firm fluctuates around 20% debt capital and the rest equity capital. Based on this capital structure, what is the WACC?

E.) What is the value of the firm, and the value of its equity?

Answer 1

(A) Current EBITDA = $ 2.05 million and Expected EBITDA Growth Rate = 2.3 %

Expected EBITDA = 2.05 x 1.023 = $ 2.09715 million

Current Depreciation = $ 233500 and Expected Growth in Depreciation = 2.3 %

Expected Depreciation = 233500 x 1.023 = $ 238871

EBITDA = $ 2097150

Less: Depreciation = $ 238871

EBIT = $ 1858279

Less: Tax @ 30 % = 0.3 x 1858279 = $ 557483.7

NOPAT (Net Operating Profit After-Tax) = $ 1300795.3

Add: Depreciation = $ 238871

Less: Capital Expenditure = 24 % of EBITDA = 0.24 x 2097150 = $ 503316

Less: Change in Net Working Capital = $ 0

Free Cash Flow to Firm (FCFF) = $ 1036350.3

(B) Cost of Debt = RIsk-Free Rate (Rf) + Default Spread = 2 + 5.5 = 7.5 %

(C) Market Risk Premium = 6.9 % (MRP) and Beta = 0.96

Cost of Equity = Rf + MRP x Beta = 2 + 0.96 x 6.9 = 8.624 %

(D) Debt to Capital = 20 % of Capital and Equity Capital = (100 - 20) = 80 %

WACC = Cost of Debt x Debt Proportion x (1-Tax Rate) + Cost of Equity x Equity Proportion = 7.5 x 0.2 x (1-0.3) + 8.624 x 0.8 = 7.9492 %

(E) If the EBITDA and Depreciation both rise at the same rate of 2.3 % per annum and the Capital Expenditure remains at 24 % of EBITDA along with zero change in net working capital, the FCFF will also increase at a perpetual constant growth rate of 2.3 %

Therefore, Firm Value = Expected FCFF / (WACC - Constant Perpetual Growth Rate) = 1036350.3 / (0.079492 - 0.023) = $ 18345080.72

Value of Debt = $ 4900000

Value of Equity = Value of Firm - Value of Debt = 18345080.72 - 4900000 = $ 13445080.72