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 26% of the company’s present value, and you believe that at this capital structure the company’s debt holders will demand a return of 6% and stockholders will require 13%. The company is forecasting that next year’s operating cash flow (depreciation plus profit after tax at 40%) will be $64 million and that investment in plant and net working capital will be $26 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?

b. What is the value of the company’s equity?

Answer 1

(a) Debt = 26 % , Common Equity = 100 - 26 = 74 % , Cost of Debt = Return Required by Debtholders = 6 % and Required Return on Equity = 13 %

Tax = 40 %

Current Operating Cash Flow (OCF) = $ 64 million and Investment Expenditure = Net Working Capital (NWC) + Investment in Plant = II = $ 26 million

Current Free Cash Flow (FCF) = FCF0 = OCF - II = 64 - 26 = $ 38 million

If the OCFs and Investment Expenditures grow at 4 % in perpetuity, then the difference of the two quantities i.e FCF should also grow in perpetuity at 4 %.

Weighted Average Cost of Capital (WACC) = 6 x (1-0.4) x 0.26 + 13 x 0.74 = 10.556 %

Total Value of Firm = [FCF0 x (1.04)]/[WACC - Perpetual Growth Rate] = [38 x 1.04] / [ 0.10556 - 0.04] = $ 602.8066 million

(b) Debt = 26 % of Company's Present Value = 0.26 x 602.8066 = $ 156.7297 million

Value of Company Equity = 602.8066 - 156.7297 = $ 446.0769 million