You have been asked to estimate the expected free cash flow to the firm next yea
ID: 2771213 • Letter: Y
Question
You have been asked to estimate the expected free cash flow to the firm next year of Lymon Enterprises, a beverage company.
The firm has reported the following:
• The earnings before interest and taxes in the most recent year amounted to $ 150 million. The tax rate of the firm is 40%.
• The firm had operating lease payments of $ 50 million in the most recent year, and has commitments to make similar payments each year for the next 10 years.
The pre-tax cost of debt for the firm is 8%.
The book value of equity is $ 400 million and the book value of debt (not including operating leases) is $ 100 million.
The expected growth rate in the earnings before interest and taxes next year is 10% and the Return on Capital will remain unchanged from this year’s level.
Estimate the adjusted (for operating leases) return on capital for the firm.
Explanation / Answer
Use the following formulas to calculate the value of adjusted return on capital as follows:
Adjusted return on capital = (operating profit-tax-lease payment) / (book value of equity + debt)
Capital employed = shareholders equity + liabilities
Use the following values to calculate the value of adjusted return on capital:
Operating profit that is earning before tax is $150 million.
Tax rate is 40%.
Lease payment is $50 million.
Pretax cost of debt is 8%.
Book value of equity is $400 million.
Book value of debt (no including operating lease) is $100million.
Substitute the values in above equation to calculate the value of adjusted ROC:
= 9.80%(165-66-50)/500
= 0.96%
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