Higgs Bassoon Corp. borrowed heavily and is reducing its debt over the next 3 ye
ID: 2710398 • Letter: H
Question
Higgs Bassoon Corp. borrowed heavily and is reducing its debt over the next 3 years to a sustainable level. Higgs Bassoon has forecast free cash flows and the tax savings due to the deductibility of interest expense for the next three years, as shown below. The FCF and tax savings are expected to grow at a constant rate of 5% after Year 3. The unlevered cost of equity is 11% and its tax rate is 34%. What is the horizon value of unlevered firm?
Free cash flow
1 2 3Free cash flow
$1,000 $1,200 $1,350 Tax savings $320 $240 $160Explanation / Answer
First, Calculate the free cash flow for each given period
Free cash flow = Earning + Tax Saving
Free cash flow + Tax Saving = Total Free Cash flow
1000+320 = 1320
1200+240 = 1440
1350+ 160 = 1510
Second , Determine the effective cost of Capital
Cost of Capital = ( 1- Tax Rate )* Cost of Capital
(1-0.34)*11
= 7.26%
Determine the horizone value of third year . Because the growht rate will be 5 % from 3rd year and beyond so the horizone value of 3rd year is calculated as under
( free cash flow for year 3 ) / (Rate of return- Growth Rate )
(1510/0.0726-0.05)
20798.85
Fourth , Calculate the horizone value of the firm
Year Total free cash flow + Horizone value = Total Cash flow P.V. Factor at 7.26% Discounted Cash Flow
1 1320 0 1320 0.9323 1230.65
2 1440 0 1440 0.8692 1251.66
3 1510 20798.85 22308.85 0.8104 18078.56
Horizone value of the Firm is ....................................................................................20560.87
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