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 27% 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 40%) will be $65 million and that investment in plant and net working capital will be $27 million. Thereafter, operating cash flows and investment expenditures are forecast to grow in perpetuity by 4% a year.

a. What is the total value of Icarus? (Do not round intermediate calculations. Enter your answer in millions rounded to the nearest whole dollar amount.)

b. What is the value of the company’s equity? (Do not round intermediate calculations. Enter your answer in millions rounded to 1 decimal place.)

Answer 1

(a)- Total value of Icarus

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [{5.00 x (1 – 0.40)} x 0.27] + [12.00% x 0.73]

= [3.00% x 0.27] + [12.00% x 0.73]

= 0.81% + 8.76%

= 9.57%

Free Cash Flow = Operating cash flow – Investment in Plant & Net working capital

= $65 Million - $27 Million

= $38 Million

Total Value of Icarus = Free Cash flow / (WACC – g)

= $38 Million / (0.0957 – 0.04)

= $38 Million / 0.0557

= $682 Million

“Hence, the Total Value of Icarus will be $682 Million”

(b)- The value of the company’s equity

The value of the company’s equity = Total Value of Firm x (1 – Debt Ratio)

= $682 Million x (1 – 0.27)

= $682 Million x 0.73

= $498.0 Million

“Hence, the value of the company’s equity will be $498.0 Million “