Question

You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating income of $350,000. Income has grown 5% annually during the last five years, and it is expected to continue growing at that rate into the foreseeable future. The annual change in working capital is $30,000, and capital spending for maintenance exceeded depreciation in the prior year by $20,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. By introducing modern management methods, you believe the pretax operating income growth rate can be increased to 7% beyond the second year and sustained at that rate into the foreseeable future.

The ten-year Treasury bond rate is 6%, the equity risk premium is 6.5%, and the marginal federal, state and local tax rate is 40%. The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 2.5 and 2.0, respectively. The business's target debt-to-equity ratio is 1, and its pretax cost of borrowing, based on its recent borrowing activities, is 8%. The business-specific risk premium for firms of this size is estimated to be 6.5%. The liquidity risk premium is believed to be 18%, relatively low for firms of this type due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain after the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to pay a 13% premium to reflect the value of control.

a- What is free cash flow to the firm in year 1?

b- What is free cash flow to the firm in year 2?

c- What is the firm’s cost of equity?

d- What is the firm’s after-tax cost of debt?

E- What is the firm’s target debt-to-total capital ratio?

F- What is the weighted average cost of capital?

G- What is the business worth?

               

(Note: The first two terms represent the PV of the firm’s operating cash flows before the application of modern management methods is fully implemented; the third term is the terminal value and reflects the anticipated sustained improvement in cash flows when the benefits of the new management techniques are fully realized.)

Answer 1

1. Free cash flow to the firm in year 1 = 350,000*1.05 -30,000*1.05 -20,000*1.05 = 315,000

2. Free cash flow to the firm in year 2 =350,000*1.05^2 -30,000*1.05^2 -20,000*1.05^2 = 330,750

3. First, we calculate the unleverd beta : Unlervered beta = levered beta/(1+(1-tax rate)*D/E) = 2.5/(1+(1-0.4)*2) = 1.13636

Levered beta for this firm (this restaurant) = 1.8182

Cost of equity = risk free return + beta * equity market risk premium = 6 + 1.81812*6.5 = 17.8182%

4. After tax cost of debt = petax cost of debt *(1-tax rate) = 8*(1-0.4) = 4.8%

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