Question

QUESTION
ABC Ltd. is a private firm owned by Mr. X. It produces and sells accounting software. The firm had revenues of Sh.10 million in the most recent year, on which it made earnings before interest and taxes of sh. 1.2 million.
The firm had debt outstanding of sh.3 million, on which pre-tax interest expenses amounted to sh. 0.3 million. The book value of equity is sh. 3 million.
The average beta of publicly traded firms that are in the same business is 1.2, and the average debt-equity ratio is 0.2 (based upon the market value of equity).
The market value of equity of these firms is, on average, three times the book value of equity. All firms face a 30% tax rate. Capital expenditures amounted to sh.2 million in the most recent year, and were twice the depreciation charge in that year. Both items are expected to grow at the same rate as revenues for the next five years, and to offset each other in steady state. The revenues of this firm are expected to grow 20% a year for the next five years, and 5% after that. The treasury bond rate is 7% and the average return on market is estimated at 12 % . Required: a) Estimate the cost of equity for this private firm b) Estimate the cost of capital for this private firm c) Enterprise value of ABC limited

Answer 1

a) Cost of equity= By CAPM Model,

Cost of equity= Rf+ B(Rm-Rf) where Rf= risk free rate, B= beta, Rm= market rate

Given, Rf= treasury bond rate= 7%, B=1.2, Rm= 12%, Thus, Cost of equity= 7+ 1.2(12-7)= 13%

b) Cost of capital, Given debt equity ratio= 0.2 , so weight of debt= 0.1667 and weight of equity= 0.8333

cost of capital by WACC (Weighted average cost of capital)= Weight of debt*cost of debt*(1-t) + Weight of equity*cost of equity

cost of debt= interest/ debt = 0.3mn/3mn= 10%

Thus, wacc= 0.01667*0.1*(1-0.3) + 0.8333*0.13

wacc= 0.0117+ 0.1083

wacc= 12%

c) Enterprise value= Market value of debt+ market value of equity - cash and cash equivalents

Market value of equity= 3* book value of equity= 3*3mn= 9mn

Give, debt/equity ratio based on market value=0.2

so, debt/ equity= 0.2

debt/ 9= 0.2

so debt= 1.8

so EV= 1.8+9= 2.7 MN