Icarus Airlines is proposing to go public, and you have been given the task of e
ID: 2790216 • Letter: I
Question
Icarus Airlines is proposing to go public, and you have been given the task of estimating the value of its equity. Management plans to maintain debt at 34% of the company’s present value, and you believe that at this capital structure the company’s debt holders will demand a return of 8% and stockholders will require 11%. The company is forecasting that next year’s operating cash flow (depreciation plus profit after tax at 40%) will be $72 million and that investment in plant and net working capital will be $34 million. Thereafter, operating cash flows and investment expenditures are forecast to grow in perpetuity by 4% a year.
a. What is the total value of Icarus? (Do not round intermediate calculations. Enter your answer in millions rounded to the nearest whole dollar amount.)
b. What is the value of the company’s equity? (Do not round intermediate calculations. Enter your answer in millions rounded to 1 decimal place.)
Explanation / Answer
The weighted average cost of capital (WACC) of the company:
WACC = wd*rd *(1 - t) + we*re
Where,
wd is the proportion of debt of the company = 34%
rd is the before-tax cost of debt = 8%
t is the company’s tax rate = 40%
we is the proportion of equity of the company = 1- 34% = 66%
re is the cost of equity = 11%
Therefore
WACC = 34% * 8% *(1-40%) + 66% * 11%
=8.892%
What is the total value of Icarus?
Now we can compute the value of the firm by using the WACC method.
Total Firm’s value = Free Cash Flow / (WACC – g)
Where, expected Free cash flow = next year’s operating cash flow (depreciation plus profit after tax) - investment in plant and net working capital
=$72 million -$34 million
=$38 million
And perpetual growth rate g = 4% per year
Therefore
Total value of Icarus = $ 38 million / (0.08892 – 0.04) = $776.78 Million
What is the value of the company’s equity?
Value of the company’s equity = Total value of Icarus *(1– % value of its debt)
= $776.78 Million *(1-34%)
= $512.67 million
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