Question

In the year prior to going public, a firm has revenues of $20 million and net income after taxes of $2 million. The firm has no debt, and revenue is expected to grow at 20% annually for the next five years and 5% annually thereafter. Net profit margins are expected remain constant throughout. Capital expenditures are expected to grow in line with depreciation and working capital requirements are minimal. The average beta of a publicly traded company in this industry is 1.50 and the average debt/equity ratio is 20%. The firm is managed very conservatively and does not intend to borrow through the foreseeable future. The Treasury bond rate is 6% and the tax rate is 40%. The normal spread between the return on stocks and the risk free rate of return is believed to be 5.5%. Reflecting the slower growth rate in the sixth year and beyond, the discount rate is expected to decline by 3 percentage points. Estimate the value of the firm’s equity.

1. What is the beta of this firm?

2. What is the cost of equity in the first five years? (Provide your answer in decimals, i.e., enter 0.1 instead of 10%.)

3. What is the total value of this firm? (Answer must be in million dollars, but write the number only.)

Answer 1

1.

βu (unlevered beta) for comparable firms

= Average β/ (1 + D/E (1-t))

= 1.5/ (1 + .2 x .6)

= 1.5/1.12

= 1.34

        

2.

COE(1-5) = Rf + βu (Rm – Rf)

= .06 + 1.34 (.055)

= 13.4%

3.

Projected free cash flows (FCFE) to the firm during the next five years and for the terminal year are as follows:

Year	Net income
1	$5.23
2	$4.98
3	$4.15
4	$3.46
5	$2.88
Terminal	$2.40

P0,(1-5 )= $2.4/1.134 + $2.88/(1.134)2 + $3.46/(1.134)3 + $4.15/(1.134)4 + $4.98/(1.134)5 =

= $2.40/1.134 + $2.88/1.29 +$3.46/1.46 + $4.15/1.65 + $4.98/1.88

= $2.12 + $2.23 + $2.37 + $2.52 + $2.65

= $11.89

PTV = Terminal Value = {$5.23 / (.104 - .05)}/1.13455 = {$5.23 / .054}/1.88 = $96.85/1.88 = $51.52

Total PV0 = $11.89 + $51.52 = $63.41

answered by: anonymous