C4 A4 Q6 . You have a challenge ahead of you because you have been given a valua

Question

C4 A4 Q6

. You have a challenge ahead of you because you have been given a valuation exercise by your potential employer to demonstrate the skills you have learned in a Massive Open Online Course (MOOC) offered by one of the leading universities of the world. As part of your three-day final interview, you are expected to estimate the value of a company. Your potential employer is keen to determine whether you understand both big picture issues and the details, and she therefore presents you with many questions.

Specifically, you have been asked to value an existing well-known company, Dramazon, Inc., but using only the information provided to you (modified to camouflage the real identity of the company). Dramazon, Inc. is expected to have revenues of $1 billion next year (t = 1) that are expected to grow at 5% per year thereafter for the foreseeable future. The data presented to you shows that COGS and SGA are expected to remain at 55% and 20% of revenues for the foreseeable future. For simplicity, you are also asked to make the following assumptions: (a) depreciation is 10% of revenues; (b) it is safe to assume that capital expenditures will be approximately equal to depreciation; and, (c) Dramazon, Inc. will be able to manage with no changes in working capital. After all, it has already demonstrated to the world how to manage working capital: reduce costs of inventory by acquiring warehouses in the middle of nowhere, make customers pay well in advance while paying suppliers as late as possible.

You are also provided some detailed information about Dramazon, Inc.’s main competitors and some market data. The business competitors have an average beta of equity of 1.50, and an average debt/equity ratio of 25% with an average beta of debt of 0.15. The risk free rate is 2.50% and the expected market risk premium (the difference between the market return and the risk free rate) is 4.00% for the foreseeable future. Assume that the tax rate is 34%, the interest payments on debt are tax deductible and the tax shield on debt is as risky as the assets of a business. Suppose the equity beta of Dramzon, Inc. is 1.23, what is its current debt/equity ratio?

Explanation / Answer

If equity beta of Dramzon, Inc. is 1.23, then its current debt/equity ratio is 2.5 means

Beta levered = (beta unlevered) x 1 + (1 - tax rate) x (debt/equity)
0.15=1.5*1+(1-34/100)* debt/equity
0.15=1.5+0.66* debt/equity
debt/equity*0.66=0.15+1.5=1.65
=1.65/0.66
=2.5 or 250%

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