Question

You are a manager in a start-up firm based in Bengaluru. The firm is planning to go public and you have been tasked at arriving at an approximate valuation for the firm. The firm is in the business of providing medical grade pure water. The asset beta of the firms’ in the industry with similar size is 1.3 and 1.4. The risk free rate is 5% and the market risk premium is 7%. At present, the firm doesn’t have any debt, however the management intends to target a debt equity ratio of 1. The cost of debt for similar firms with similar capital structure is 8.5%. What is the WACC of the firm given the intended capital structure ? What should be the value of the firm if the Free cash flow to the firm you have arrived at is INR 12 million and is expected to grow at a rate of 2% in perpetuity.

Answer #1

Cost of debt (provided) = 8.5%

Cost of equity = Rf + b * MRP

= 5% + 1.35 * 7%

= 5% + 9.45% = 14.45%

where,

beta of firms with similar size = 1.3 & 1.4 => Average beta = 1.35 (b)

Risk free rate of return (Rf)= 5%, Market risk premium (MRP) = 7%

Debt Equity ratio = 1, implying 50:50 as the debt to equity

Weighted average cost of capital (WACC) of the firm =

Cost of debt * weight of debt + Cost of equity * weight of equity

= 8.5% * 50% + 14.45% * 50%

= 4.25% + 7.225% = 11.475%

Now, to calculate the value of the firm,

Free cash flow to the firm arrived at 12 million, growth rate = 2%

WACC = { [ Free cash flows * (1 + growth rate) ] / firm value} + growth rate

=> firm value = [ Free cash flows * (1 + growth rate) ] / (WACC - growth rate)

=> firm value = [12,000,000 * (100%+2%)] / (11.475% - 2%)

=> firm value = 12,240,000 / 9.475% = Approximately INR 129.182 million

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