Question

LockBenz Corporation, one of the largest defense contractors in the world, reported EBITDA[1] of $1,290 million in 2019, prior to interest expenses of $215 million and depreciation charges of $400 million. Capital expenditures in 2019, amounted to $450 million, and working capital was 7% of revenues. Revenues in 2019 were $13,500 million.

The firm expects revenues, earnings, capital expenditures and depreciation to grow at 8% a year from 2019 to 2024, after which time the growth rate is expected to drop to 3%. Capital spending is expected to offset depreciation in the stable state period.

The debt outstanding was $3.5 billion (in book value terms) but was trading at a market value of $3 billion. The company’s debt is rated AA. Similar AA bonds have a yield to maturity of 8%. The company’s stock has a beta of 1.2, the market risk premium is 5% and Treasury bonds have a yield of 6%. The company’s effective marginal tax rate was 40%. Assume the company’s optimal debt ratio is 40%.

1. What discount rate should be used to value the company’s cash-flows?

2. Estimate the Free cash flow to the firm (FCFF) for 2020 to 2024 (5 years).

Answer 1

a) WACC = wd x rd x (1 - tax) + we x re

where, wd - weight of debt = 40%, rd - cost of debt = 8%, we - weight of equity = 60%, re - cost of equity

Using CAPM<, re = Rf + beta x MRP = 6% + 1.2 x 5% = 12.0%

=> WACC = 40% x 8% x (1 - 40%) + 60% x 12% = 9.12%

b) FCFF = EBIT x (1 - tax) + Depreciation - Capex - Change in WC

where, WC = 7% x Revenues

and we need to consider change in WC while calculating WC.

Revenues, EBITDA, Depreciation and Capex grows at 8%

LockBenz	2019	2020	2021	2022	2023	2024
Revenues	13,500	14,580	15,746	17,006	18,367	19,836
EBITDA	1,290	1,393	1,505	1,625	1,755	1,895
Depreciation	400	432	467	504	544	588
EBIT	890	961	1,038	1,121	1,211	1,308
EBIT x (1 -tax)	534	577	623	673	727	785
Capex	450	486	525	567	612	661
WC	945	76	82	88	95	103
FCFF		447	483	522	563	608