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 37% of the company’s present value, and you believe that at this capital structure the company’s debt holders will demand a return of 7% and stockholders will require 14%. The company is forecasting that next year’s operating cash flow (depreciation plus profit after tax at 40%) will be $75 million and that investment in plant and net working capital will be $37 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? (Do not round intermediate calculations. Enter your answer in millions rounded to the nearest whole dollar amount.)

b. What is the value of the company’s equity? (Do not round intermediate calculations. Enter your answer in millions rounded to 1 decimal place.)

Answer 1

Answer (a)

WACC = Cost of equity * Equity % + Cost of debt * (1 - Tax rate) * Debt %

= 14% * (1 - 37%) + 7% * (1 - 40%) * 37%

= 10.374%

WACC = 10.374%

Free Cash flow (FCF) next year = Operating cash flow next year - Net investment in plant and net working capital next year

= 75 - 37

= $38 million

Perpetual growth rate = 4% a year

Current Value of company = FCF next year / (WACC - Constant growth rate) = 38 / (10.374% - 4%)

= 596.17194854

= $596 million

Total value of Icarus = $596 million

Answer (b):

Value of company's equity = Total value of Icarus * (1 - Debt %)

= 596.17194854 * (1- 37%)

= 375.5883

= $375.6 million

Value of company's equity = $375.6 million