C4 A3 1-3 In response to the comment received, this section of the assignment de

Question

C4 A3 1-3

In response to the comment received, this section of the assignment deals with unlevering and relevering, thus I think there is a different approach to calculate return on equity.

You have been asked to value one of the biggest global companies, Malicaca, Inc., but using only the information provided to you (modified to camouflage the real identity of the company). Malicaca, Inc. is expected to have revenues of $500 million next year (t = 1) that are expected to grow at 8% per year thereafter for the foreseeable future. The data presented to you shows that COGS and SGA are expected to remain at 50% and 10% of revenues for the foreseeable future. For simplicity, you are also asked to make the following assumptions: (a) depreciation is 15% of revenues; (b) it is safe to assume that capital expenditures will be approximately equal to depreciation; and, (c) Malicaca, Inc. will be able to manage with no changes in working capital.

You are also provided some detailed information about the Malicaca, Inc.’s main competitors and some market data. The business competitors have an average beta of equity of 2.50, and an average debt/equity ratio of 35% with an average beta of debt of 0.25. 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. The tax rate is 34%. Assume that the interest payments on debt are tax deductible and for the industry/comparables the tax shield on debt is as risky as the assets of a business.

a) What is the average return on equity in Malicaca, Inc.’s industry?

b) The average return on debt in Malicaca, Inc.’s industry is

c) What is the average return on assets in Malicaca, Inc.’s industry?

d)

Same info as above but new now:

Competitors in the business have approx. the same D/E = 35%

The average WACC in Malicaca, Inc.’s industry is

Explanation / Answer

a) What is the average return on equity in Malicaca, Inc.’s industry= RFR+(Equity Beta*MRP)=2.5%+(2.5*4%)= 12.5% b) The average return on debt in Malicaca, Inc.’s industry is= RFR+(Debt Beta*MRP)= 2.5%+(0.25*4%)= 3.5% After-tax cost of debt=3.5%*(1-34%)= 2.31% c) What is the average return on assets in Malicaca, Inc.’s industry= 12.5%+3.5%= 16% d. The average WACC in Malicaca, Inc.’s industry is Type of capital Cost Proportion Cost*proportion Equity 12.5% 1 0.125 Debt 2.31% 0.35 0.008085 Total 1.35 0.133085 WACC= 0.133085/1.35= 9.86% Free Cash Flow (t=1)calculations Revenues 500 COGS 50%*500 -250 SGA 10%*500 -50 Depn. 15%*500 -75 EBIT 125 Tax at 34%*125 -42.5 EAT 82.5 Add Back depn. 75 CFO 157.5 Less: Capex -75 Less:Inc.in NWC 0 FCF(1) 82.5 Value of Firm= (Using Dividend Discount Model) Terminal value of FCF at t=1 (82.5*1.08)/(9.86%-8%) 4790.322581 FCF at t=0 = 4790.322581/1.0986 4360.388295 ie. 4360 Millions

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