Icarus Airlines is proposing to go public, and you have been given the task of e

Question

Icarus Airlines is proposing to go public, and you have been given the task of estimating the value of its equity. Management plans to maintain debt at 36% of the company’s present value, and you believe that at this capital structure the company’s debtholders will demand a return of 6% and stockholders will require 13%. The company is forecasting that next year’s operating cash flow (depreciation plus profit after tax at 40%) will be $74 million and that investment expenditures will be $36 million. Thereafter, operating cash flows and investment expenditures are forecast to grow in perpetuity by 4% a year.

What is the value of the company’s equity? (Do not round intermediate calculations. Enter your answer in millions rounded to 1 decimal place.)

Use the weighted-average cost of capital to value a business given forecasts of its future cash flows

Icarus Airlines is proposing to go public, and you have been given the task of estimating the value of its equity. Management plans to maintain debt at 36% of the company’s present value, and you believe that at this capital structure the company’s debtholders will demand a return of 6% and stockholders will require 13%. The company is forecasting that next year’s operating cash flow (depreciation plus profit after tax at 40%) will be $74 million and that investment expenditures will be $36 million. Thereafter, operating cash flows and investment expenditures are forecast to grow in perpetuity by 4% a year.

Explanation / Answer

a) WACC of Icarus = 6(1-0.04)*0.36 + 13*0.64 = 1.30 + 8.32 = 9.62%

Free cash flow to firm for the Year 1 = operating cash flow - investment = $74m - $36m = $38m

Terminal cash flow to the firm = 38*1.04/(0.0962 - 0.04) = 39.52/0.0562 = $703.20m

Value of the firm (Icarus) = (38 + 703.20)/1.0962 = $676 millions.

b) Value of company's equity = 676.15/(1 - 0.36) = $432.7 millions.

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