Question

Corox Inc. is a chemical manufacturing company which reported earnings before interest and taxes of $ 150 million this year. The firm has a cost of capital of 10%, a tax rate of 40% and expects earnings to grow 5% a year in perpetuity. You know that the firm has no working capital requirements but does have net capital expenditures that it needs to make to grow. The firm has return on capital of 12.5% that it expects to maintain in perpetuity.

a. Estimate the net capital expenditures for Corox, given the expected growth rate and return on capital.

b. Estimate the value of the firm.

Answer 1

Given EBIT= $150 million

cost of capital i= 10%

tax rate t =40%

growth rate g= 5%

return on capital r = 12.5%

net working capital = 0

a.

Reinvestment rate = [net capital expenditures - net working capital]/ [EBIT(1-t)]

Reinvestment rate = net capital expenditures/ [EBIT(1-t)]

net capital expenditures = Reinvestment rate * [EBIT(1-t)]

Reinvestment rate = growth rate / return on capital = 5%/12.5% = 40%

net capital expenditures = 0.4 * [150 million (1-0.4)]

= 0.4 * 150 million * 0.6 = $36 million

Therefore Net capital expenditures = $36 million.

b.

value of firm =[ EBIT(1-t) - Net capital expenditures - net working capital ] * [(1+ g)/(i-g)]

value of firm = [150 million (1-0.4) - 36 million - 0] * [ (1+ 0.05)/ (0.10 - 0.05)

= [150 million * 0.6 - 36 million]*[1.05 / 0.05]

=54 million *21 = $1134 million

Value of the firm = $1134 million