Question

Icarus Airlines is proposing to go public, and you have been given the task of estimating the value of its equity. Management plans to maintain debt at 39% of the company’s present value, and you believe that at this capital structure the company’s debt holders will demand a return of 5% and stockholders will require 12%. The company is forecasting that next year’s operating cash flow (depreciation plus profit after tax at 21%) will be $77 million and that investment in plant and net working capital will be $39 million. Thereafter, operating cash flows and investment expenditures are forecast to grow in perpetuity by 4% a year.

Answer 1

The WACC is computed as follows:

After tax cost of debt= 5% * (1-21%) = 3.95%

Therefore, WACC = 39% * 3.95% + 61% * 12% = 8.86%.

Cash flow at the end of 1st year = $77 -$39 = $38 million.

Present value of cash flow at the end of 1st year = $38 / (1+8.86%) = $34.91 million.

Free cash flow at the end of second year = $38 * (1 + 4%) = $39.52 million.

Therefore, terminal value is calculated as follows:

$39.52 / (8.86% - 4%) = $813.09 million.

Present value of terminal value is $813.09 / (1 + 8.86%) = $746.91 million.

The total value of Icarus Airlines is $34.91 + $746.91 = $781.81 million.

The total value of Icarus Airlines is $781.81 million and it is given that the company plans to maintain debt at 39% of the present value of the company.

Hence, the equity value of the entity is $781.81 – 39% * $781.81 = $476.91 million.