Question

You are analyzing Delta Enterprises, a small publicly traded company with

$50 million of debt outstanding, and 25 million shares, trading at $10/share.

The firm generated $40 million in after-tax cash flows last year, and you esti-

mate that these cash flows will grow 2% a year in perpetuity and that the cost

of capital for the firm is 12%.

a. Estimate a value per share for the firm, assuming it has no cash balance.

b. Now assume that you find out that a significant portion of the firm’s revenues

comes from one customer and that there is a 20 percent chance that this con-

tract will be lost next year. Assuming that a lost contract will result in a 50%

drop in the after-tax cash flows, estimate the value per share today. (You can

assume that the growth rate and cost of capital will be unaffected).

Answer 1

a. Delta Enterprises generates $40 million in after-tax cash flows last year; the cash flows are a growing perpetuity therefore the PV of a growing perpetuity can be calculated in following manner

Value of firm = PV of future Cash Flows = After-tax cash flow (1+g) / (k –g)

Where,

After-tax cash flow last year = $40 million

Cost of capital of the firm k = 12% per year

And perpetual growth rate of cash flow, g = 2% per year

Therefore,

Value of firm = $40 million * (1+2%) / (12% – 2%)

= $408 million

Value of the equity of the firm = Value of the firm – value of debt

As the firm has $50 million of debt outstanding; therefore

Value of the equity of the firm = $408 million - $50 million

= $358 million

Now, Value per share for the firm = Value of the equity of the firm/ number of shares outstanding

Where number of shares outstanding = $25 million

Therefore

Value per share for the firm = $358 million / $25 million

= $14.32

b. Assume that you find out that a significant portion of the firm’s revenues comes from one customer and that there is a 20 percent chance that this contract will be lost next year. Assuming that a lost contract will result in a 50% drop in the after-tax cash flows

There are two situations-

• A 20 percent chance that this contract will be lost next year; If contract lost, it will result in a 50% drop in the after-tax cash flows
• A 80 percent chance that this contract will not be lost next year; If contract not lost, the after-tax cash flows will remain same

Therefore expected after-tax cash flows = 20% * ($40 million *50%) + 80% * $40 million

= $4 million + $32 million = $36 million

Now, the Value of firm = PV of future Cash Flows = After-tax cash flow (1+g) / (k –g)

Where,

After-tax cash flow last year = $36 million

Cost of capital of the firm k = 12% per year

And perpetual growth rate of cash flow, g = 2% per year

Therefore,

Value of firm = $36 million * (1+2%) / (12% – 2%)

= $367.2 million

Value of the equity of the firm = Value of the firm – value of debt

As the firm has $50 million of debt outstanding; therefore

Value of the equity of the firm = $367.2 million - $50 million

= $317.2 million

Now, Value per share for the firm = Value of the equity of the firm/ number of shares outstanding

Where number of shares outstanding = $25 million

Therefore

Value per share for the firm = $317.2 million / $25 million

= $12.69