Question

Ulysses Inc. is a shipping company with $100 million in earnings before interest

and taxes that is expected to have earnings growth of 10% for the next five

years. At the end of the fifth year, you estimate the terminal value using a multi-

ple of 8 times operating income (which is the average for the sector).

a. Estimate the terminal value of the firm.

b. If the cost of capital for Ulysses is 10%, the tax rate is 40%, and you expect

the stable growth rate to be 5%, what is the return on capital that you are as-

suming in perpetuity if you use a multiple of 8 times operating income?

Answer 1

Part 1)

The terminal value of the company is arrived as below:

Terminal Value = Operating Income*(1+Growth Rate)^Years*(Multiple)

_____

Here, Operating Income = $100 million, Growth Rate = 10%, Years =5 and Multiple = 8

Substituting these values in the above formula, we get,

Terminal Value = 100*(1+10%)^5*(8) = $1,288.41 (answer for Part 1)

_____

Part 2)

The return on capital is calculated as follows:

Multiple = (1-Tax Rate)*(1+Growth Rate)*(1-Reinvestment Ratio)/(WACC - Growth Rate)

_____

Here, Multiple = 8, Tax Rate = 40%, Growth Rate = 5%, Reinvestment Ratio = Growth Rate/ROC = 5%/ROC and WACC = 10%

Substituting these values in the above formula, we get,

8 = (1-40%)*(1+5%)*(1-5%/ROC)/(10%-5%)

Rearranging Values, we get,

8*(10%-5%) = .63*(1-5%/ROC)

Solving further, we get,

.6349 = (ROC-5%)/ROC

.6349*ROC = ROC - 5%

ROC = 5%/(1-.6349) = 13.696% (answer for Part 2)