Question

UVA Inc. is a company that manufactures and retails eye wear. The firm reported $ 50 million in after-tax operating income on revenues of $ 500 million in the most recent year. The company has 50 million shares outstanding, trading at $ 8 per share, and $ 150 million in debt at a current market interest rate of 8%; the corporate tax rate is 40%. The firm also has a cash balance of $ 50 million. The stock trades at 1.6 times the book value (of equity) and debt trades at book value (of debt). The unlevered beta for eyewear firms is 0.80; the risk free rate is 5% and the market risk premium is 4%.

a. Estimate the cost of capital for UVA Inc.

b. UVA had capital expenditures of $ 80 million and depreciation of $ 40 million in the most recent year. If UVA has no working capital investments and expects to maintain its existing reinvestment rate and return on capital for the next 3 years, estimate the expected annual growth rate for this period.

c. Estimate the value of UVA at the end of the third year, assuming that its growth rate drops to 4% after year 3 and it maintains its existing return on capital and cost of capital.

d. UVA has 10 million options outstanding. If you value each of the options at $ 12, estimate the value of equity per share based upon your estimated cash flows (from parts b and c).

Answer 1

a) Cost of Capital is WACC  = ( ( E ÷ V ) x Re ) + ( ( ( D ÷ V ) x Rd ) x ( 1 - T ) )

where

• Re=Cost of equity
• Rd=Cost of debt
• E=Market value of equity, or the market price of a stock *  total number of shares outstanding
• D=Market value of debt, or the total debt of a company
• T= Effective tax rate
• V=Total market value of combined equity and debt

Re=Risk Free Rate + [ Beta x ( Expected Market Return - Risk Free Rate ) ]

=5%+0.8*4%

=8.2%

Rd=( Annual Interest ÷ Total Debt ) x 100*(1-T)

=8%(1-0.4)

4.8%

E= Current Stock Price x Shares Outstanding

=1.6*8*50 million

=640 Million

D=150 Million

T=0.4

V=790 Million

So, WACC= (640/790)*8.2%+(150/790)*4.8%*(1-0.4)

=6.64%+0.55%

=7.19%

Hence, the required cost of capital is nearly 7.2%