It is the end of 2013, and KOC Inc. has just received a buyout offer from a priv
ID: 2729436 • Letter: I
Question
It is the end of 2013, and KOC Inc. has just received a buyout offer from a private equity firm. Upon receiving the offer, KOC’s board set up a special committee to evaluate the offer and to make recommendations about the transaction.
The special committee would like you to estimate the value of KOC based on management forecasts given below. Due to the nature of the transaction, you realize that the Capital Cash Flow (CCF) valuation is the most appropriate method. The valuations are to be done as of the end of 2013. KOC is subject to 37.5% tax rate.
KOC is currently debt free, but the transaction will be financed with term loans of $8.9 billion at an interest rate of 7% and bank debt of $12 billion at an interest rate of 8%. The firm pays interest during the year on its beginning-of-the-year debt balances. The outstanding debt amounts over the next five years are given below. Beyond 2018, you expect that KOC’s outstanding debt will grow with firm value.
Outstanding Debt:
Outstanding debt amounts at the end of
2013
2014
2015
2016
2017
2018
Term Loan
8,900
7,900
6,900
5,900
4,900
3,900
Bank Debt
12,000
10,894
8,892
6,517
3,523
29
Management Projections of EBIT, Depreciation, and Capital Expenditures:
Projected Fiscal Year Ending December 31st
2014
2015
2016
2017
2018
EBIT
5,360
6,537
6,927
7,628
8,123
Depreciation
1,446
1,536
1,632
1,734
1,842
Capital Expenditure
1,560
1,634
1,784
1,904
2,015
Management Projections of Net Working Capital:
2013
(Actual)
2014
2015
2016
2017
2018
Net Working Capital
348
489
584
640
659
679
Market and Interest Rate Data:
Risk-free rate = 4%
Market risk premium = 6%
Long-term growth rate = 3%
Interest rate on term loan = 7%
Interest rate on bank debt = 8%
Tax rate = 37.5%
Information about Comparable Companies:
Company
Equity Beta
Debt Beta
Total Debt ($m)
Market value of equity ($m)
RTH Healthcare
1.7
0.2
5,000
3,000
Health Management Associates
0.8
0.1
2,000
6,000
Community Health Systems
0.9
0.1
3,000
5,000
What is the cost of unlevered equity of KOC?
8.28%
7.98%
7.32%
9.86%
10.80%
Outstanding debt amounts at the end of
2013
2014
2015
2016
2017
2018
Term Loan
8,900
7,900
6,900
5,900
4,900
3,900
Bank Debt
12,000
10,894
8,892
6,517
3,523
29
Explanation / Answer
We have not been provided any information on the equity proportion of KOC company. Therefore, we will have to use the average unlevered beta value which can be derived by calculating the arithmetic mean of equity beta of comparable companies. The average unlevered beta is calculated as follows:
Average Unlevered Beta = (1.7+.8 +.9)/3 = 1.133
______
Now, we can calculate the KOC's unlevered cost of equity with the use of following formula:
Cost of Unlevered Equity = Risk Free Rate + Unlevered Beta*(Market Risk Premium)
Using the information provided in the question and unlevered beta calculated above, we get,
Cost of Unlevered Equity = 4% + 1.133*(6%) = 10.80% (which is Option E)
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