Final Exam MBAC 6060 Fall 2004

Final Exam MBAC 6060 Fall 2004

You will have three hours to complete this exam. Please take some time read the entire exam and think about the issues presented before you begin. Anything you wish to have me consider in assigning a grade should be written on the pages of the exam. Have fun.

As a newly hired financial analyst for Ralph Inc. you have been charged with estimating a value for the firm and a price per share of the currently outstanding equity. Ralph Inc is a privately held firm with only a few shareholders consisting of Ralph, his itinerant cousin Clem, and Ralph’s old dog Spooner. The information presented below has been provided for you by Ralph’s administrative assistant, Desdemona, in support of this endeavor. Last Mango Enterprises has been identified as a comparable publicly traded company.

Table 1: Ralph’s projections of expected sales, costs and cash flows for the firm (thousands of $)

Table 2: Current Balance Sheet Information for Ralph Inc (thousands of $)

Table 3: Capital Market Information

Subsequent to 2009 Ralph expects free cash flows to increase at the rate of 1% per year.

The first step in the valuation is the development of Free Cash Flow Figures

These figures show the cash flow that is expected to be generated by the firm and to be available to be paid to contributors of capital under the assumption that the firm is all equity financed. The firm is not all equity financed so of course our valuation method must account for the value of the debt tax shields in some way.

Now estimate the discount rate to apply. Use of the WACC is suggested by the stated target debt to equity ratio though one might use the APV given the constant interest expense for the forecast period. I illustrate the WACC method here. Note first that with the implied cost of debt capital (interest expense/interest bearing liabilities) that the firm’s debt is risk free. Thus we can safely use the shortened version of the conversion formula for the betas. We “unlever” the equity beta of LME (using their actual debt to equity ratio) to find an asset beta of about 1.39 = 1.7(1/(1+.3x.75)). At Ralph’s target debt to equity ratio of 0.1 (or a debt to value ratio of about 9% debt) the implied equity beta is 1.5 = 1.39(1+.1x.8). The cost of equity capital is then 15.5% note that this is lower than the cost of equity capital for LME because while they have the same underlying business risk they use more leverage. Ralph’s cost of debt capital is 5% and his tax rate is 20%. So the WACC can be estimated to be 0.09x5%x0.8 + 0.91x15.5% = 14.465% (rounding may account for small differences). Note also that this WACC is higher than the WACC for LME. While their use of more leverage increases their cost of equity capital, their more heavy use of tax advantaged debt lowers their weighted average cost of capital.

Now we value the Free Cash Flow stream. The terminal value assumption stated suggests you should value the cash flows from 2010 onward as a growing perpetuity with a 1% growth rate. The 2009 FCF value is $2,260 so for 2010 it is $2,282.6 = $2,260(1.05). Thus the terminal value is $2,282.6/(.14465-.01) = $16,952.1 as of 2009. The present value of this terminal value is $16,952.1/(1.14465)5 = $8,627. The present value of the forecast period FCF’s is $7,377.7. The total firm value is then $16,004.7 the sum of these two values. Total equity value is firm value less current debt value or $14,254.7 = $16,004.7 - $1,750. The implied price per share of outstanding equity is $142.55. Note the current debt to equity ratio is 0.12 so they are currently very close to their stated target.