ABC\'s has free cash flow for planning period years 2015 through 2017. Interest-

Question

ABC's has free cash flow for planning period years 2015 through 2017.

Interest-bearing debt:

Long-Term: 2,544

Short-Term: 522

The 10 Year T Bond rate is 5%. The Market Risk Premium is 7%. Stated interest rate on long-term debt and short term debt is 7.5%. Both are valued at 100% of par. The average unlevered beta for this industry is 0.7346. Use ABC's Debt/Equity Ratio of 2.5 and its marginal tax rate of 0.30 to compute its levered beta.

Compute, as of the end of 2014, ABC's Enterprise Value and Value of the Equity using DCF for the three planning periods and relative valuation for the Terminal Value. Use the EBITDA multiples shows above. Assume a liquidity discount of 25% for the terminal value only.

Suggested approach:

1. Compute leveraged beta using formula to convert average unlevered beta to levered beta.

2. Compute cost of capital using CAPM.

3. Compute after tax cost of debt.

4. Compute capital structure weights.

5. Compute WACC.

6. Compute PV of FCF for 2015, 2016,and 2017 using WACC.

7. Average EBITDA multiples, use the average to compute Terminal Value for a comparable public company.

8. Apply discount to convert TV to comparable private company.

9. Compute PV of TV using WACC.

10. Add PV of TV to PV of FCF's to obtain Enterprise Value.

11. Add cash and deduct interest bearing debt to obtain Equity Value.

2014 2015 2016 2017 Planning Period FCF 1,017 1,478 1,854 EBITDA 2,877 Cash 2,477

Explanation / Answer

1. We use the Hamada equation to find levered beta: BL = BU *(1+ (1-T)D/E)

BU = 0.7346

T = 30% = 0.3

D/E = 2.5

Levered Beta = BL = 0.7436*(1+(1-0.3)*2.5) = 2.02

Levered Beta = 2.02

2. Cost of equity capital using CAPM is = Rf + beta* market risk premium = 5 + 2.02*7 = 19.14%. Re = 19.14%

3.After tax cost of debt = Before tax cost*(1-Tc) = 7.5%*(1-0.3) = 5.25% . Rd = 5.25%

4. WACC

D/E = 2.5, D = 2.5E

If E = 1, D = 2.5 So Weight of equity = We= 1/3.5 = 0.2857

Weight of debt = Wd = 1-0.2857 = 0.7143

So WACC = We * Re + Wd * Rd = 0.2857 * 19.14 + 0.7143*5.25 = 9.22%

WACC = 9.22%

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