You are trying to value a private company. The company has 5 million of debt and

Question

You are trying to value a private company. The company has 5 million of debt and 4 million of book equity. The ratio of market value to book value for similar firms is 2. You decide to use this ratio to estimate the market value of equity as the input for the weights in WACC calculation. The average beta for publicly traded firms in the same industry is 2, and the average debt-to-equity ratio for public firms in this industry is 0.4. The corporate tax rate is 40%. The risk free rate is 6% and the market risk premium is 5.5%. The interest rate for debt is 10%. Here is the FCFF model for valuing the business:

Year 1 2 3 4 5 6
EBIT (EBIT grows at 15% for the first $2.30 $2.65 $3.04 $3.50 $4.02 $4.22
five years and 5% thereafter.)
EBIT (1-Tax Rate) $1.38 $1.59 $1.82 $2.10 $2.41 $2.53
  Less
(Cap. Expenditures-Depreciation) grows $.115 $.132 $.152 $.175 $.201 $0.00
at same 15% annual rate as revenue for 5 years and are offsetting thereafter) Equals FCF Assuming after 5 years, the growth rate is 5% forever.

1. What is the terminal value of the firm at the end of year 5 (in millions)?

2. What is the equity value of the firm right now (in millions)? (Note the question is not asking for firm value)

Explanation / Answer

Debt 5 Million Book value of equity 4 Million Market to book ratio 2 Market value of equity 8 Million Beta 2 Tax rate 40% Risk free rate 6% Market risk premium 5.50% Using CAPM the cost of equity 17.00% Risk free rate + Beta*market risk premium Cost of debt pre tax 10% Debt/Total capital 0.38 WACC 12.77% (Debt/Total capital *Cost of debt*(1-tax rate)+equity/total capital*cost of equity) Year 1 2 3 4 5 6 EBIT 2.3 2.65 3.04 3.50 4.02 4.22 EBIT*(1-tax rate) 1.38 1.59 1.83 2.10 2.41 2.53 Less: Capex - Depreciation 0.12 0.132 0.152 0.175 0.201 FCF 1.27 1.46 1.67 1.92 2.21 2.53 Terminal value 32.62 (FCF at year 5*(1+ Growth rate)/(WACC-Growth rate) Total value of the firm 23.72 Current value of debt 5 Equity value of firm 18.72 Total value - Value of debt

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