Question

1. The Woodridge Hotels intends to acquire Wellington Resorts using new debt financing. The Woodridge estimates interest payments of $2 million dollars per year for 3 years after the acquisition. Expected free cash flows over the same period are $5 million, $6.5 million, and $8 million, respectively. Growth rate after this period is estimated to be 4%. Tax rate is 40%. Wellington's current WACC is 12% and unlevered cost of equity (rEU) is 15%. Wellington's capital structure will be different from its pre-merger capital structure if acquired by The Woodridge. Calculate the unlevered horizon value (UHV) of the free cash flows.

   		$75.6364 million
   		$138.67 million
   		$61.4545 million
   		None of the above

Answer 1

Year 3 Free Cash Flow (FCF) = $ 8 million and post Year 3, the FCFs are expected to grow at a constant perpetual rate of 4 %.Further, the Unlevered Horion Value (UHV) of the perpetual FCFs is the present value of this perpetuity at the end of Year 3, discounted at the Unlvered Cost of Equity of 15%. This approach is usually used to determine the value of the firm through the adjusted present value (APV) method wherein the unlevered firm value is added to the present value of the firm's interest tax shield to arrive at the total firm value.

Unlevered Horizon Value = Present Value of Perpetual Growth FCFs discounted at the Unlevered Cost of Equity = [8 x 1.04 / (0.15-0.04)] = $ 75.63636 million ~ $ 75.6364 million

Hence, the correct option is (a).