Question

A group of investors plan to open a special-purpose-company that will operate in the United States. The firm will last just 5 years, at the end of which its value will be zero. The firm will produce a Free Cash Flow (FCF) of 40 million per year. The initial investment to set up the firm is estimated in 120 million (Property, Plant and Equipment, plus net working capital). The industry’s equity beta (leverage beta) is 2.1 with an average D/E ratio of 0.4. The investors plan to use a capital structure of D/E 0.75. They will get debt financing at 4% rate. The market risk premium is 7% and the risk-free rate is 3%. The industry (and the firm) has a tax rate of 30%. How much is the company worth now (enterprise value) (use Hamada formula)?

A. 19 Million

B. 21 Million

C. 141 Million

D. 198 Million

Answer 1

1]	Beta unlevered = levered beta/[1+(1-t)*D/E] = 2.1/(1+0.7*0.4) =	1.64
	Beta relevered for the desired leverage = Unlevered beta*[1+(1-t)*D/E]= 1.64*(1+0.7*0.75) =	2.50
	Cost of equity per CAPM for the SPC = Risk free rate+Beta*Market risk premium = 3%+2.50*7% =	20.50%
	After tax cost of debt = 4%*0.70 =	2.80%
	WACC = Cost of equity*Weight of equity+After cost of debt*Weight of debt = 20.50%*1/1.75+2.80%*0.75/1.75 =	12.91%
2]	EV = PV of FCF = 40*(1.1291^5-1)/(0.1291*1.1291^5) =	$                141.00	million
	Answer: [C] 141 million