Question

The MoMi Corporation’s cash flow from operations before interest and taxes was $2 million in the year just ended, and it expects that this will grow by 5% per year forever. To make this happen, the firm will have to invest an amount equal to 20% of pretax cash flow each year. The tax rate is 21%. Depreciation was $200,000 in the year just ended and is expected to grow at the same rate as the operating cash flow. The appropriate market capitalization rate for the unleveraged cash flow is 12% per year, and the firm currently has debt of $4 million outstanding. Use the free cash flow approach to calculate the value of the firm and the firm’s equity. (Enter your answer in dollars not in millions.)

Answer 1

Solution :-

Firm's value = Free Cash Flow to Firm discounted at the WACC

WACC = 12%

growth = 5%

FFCF1 would be the next Free Cash Flow of the Firm

FCFF = EBIT - Income Tax + Depreciation - Working Capital Investment

Working Capital Investment = 20% of Pretax Cash Flow

EBIT = OCF - Depreciation

Therefore,

Working Capital Investment = $2,000,000 x 20% = $400,000

Depreciation = $200,000

Tax = 0.21 x ($2,000,000 - $200,000) = $378,000

EBIT = OCF- Depreciation = $2,000,000 - $200,000 = $1,800,000

FCFF0 = $1,800,000 - $378,000 + $200,000 - $400,000 = $1,222,000

FFCF x (1+g) = FFCF1 = $1,222,000 x 1.05 = $1,283,100

Now, Value of firm is calculated as:

$1,283,100 / (0.12 - 0.05) = $18,330,000

Equity value = Firm value - Market value of debt

= $18,330,000 - $4,000,000

= $14,330,000

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