Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common sharehold
ID: 2740272 • Letter: R
Question
Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common shareholders’ equity at book value of $8,000. The market value of its common stock is $12,000 and the market value of its debt is the same as that on the balance sheet ($4,000). ROC's current market equity beta is 1.5. The risk-free rate in the economy is 3.5% and the market risk-reimium is 7%.
The firm faces 40% marginal tax rate. You are planning to to buy the firm with 50 percent common equity and 50 percent debt carrying an interest rate of 12 percent (the same as its current interest rate cost). Your forecasted free cash flow to both debt and equity stakeholders are given below. The free cash flows are expected to grow 4 percent annually forever after Year 5.
What is ROC's continuation value at the end of year 5 (not its present value)?
Year Free Cash Flow to Debt & Equity holders 1 $1,200 2 $1,560 3 $1,700 4 $1,980 5 $2,100Explanation / Answer
Continuation Value is well known as Terminal Value which is a value of an asset at a specified future valuation date considering various factors such as Interest rate,Current value and a stable growth rate.
Terminal Value can be formulated as:
Terminal value= Final Projected year cash flow * (1+growth rate) / {discount rate-growth rate}
In order to arrive at Terminal Value we need to first determine Disrount rate.As in the given question ROC has a capital structure consisting of both debt and equity, weighted average cost of capital will be best suited to serve the purpose of discount rate.
Weighted Average cost of capital is formulated as:
WACC= Cost of Equity + Cost of Debt
={Risk free rate+Equity Beta(Market risk premium - Risk free rate)*Equity/Debt+equity + { Current rate of Debt(1-tax rate)*Debt/Debt+Equity}
={3.5+1.5(7-3.5)*.5} + {0.12*.6*.5}
=9.725%
=10%(rounded off)
Now as we have determined the discount rate as 10%,we can easily calculate the terminal value of ROC at the end of year 5 is as :
Terminal Value = Final Projected year Cash Flow * (1+growth rate) / Discount rate - growth rate
In the given question,
Final Projected year cash flow i.e Cash flow at year 5 = $2100
Growth rate = 4%
Discount rate = 10%
Therefore, Terminal Value is calculated as:
= $2100*(1+4%)/ (10-4)
={$2100*1.04}/6
=$2184/6
=$364
and Continuation value without discounting comes out to be $2184
Thus, Second option is correct
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