Liverpool Ferries is a navigation company. Until last year Liverpool had no debt

Question

Liverpool Ferries is a navigation company. Until last year Liverpool had no debt, and last year its operations had an expected net income of 2 million GBP. At the end of the year the company undertook some debt so that the debt-to-equity ratio is now equal to 1.6 and will be kept constant by the company. There is one ferry that will be fully depreciated in the next three years, with annual depreciation installments of 300,000 GBP each. After that all assets will be fully depreciated and no new asset will be acquired. The expected return on levered equity for Liverpool is 14.60% and the cost of debt is 8%. The tax rate on corporate earnings is 23% and the depreciation tax shield is as risky as the other unlevered cash-flow of the company. What is the value of Liverpool's asset, if the expected EBITDA of the company is constant?

A. 19,746,813
B. 23,891,918
C. 25,932,002
D. 26,311,114

Right answer is B, thank you to only post a comment if you have the right answer.

Explanation / Answer

Liverpool Ferries

Net Income = 2000000

D/E = 1.6 or, D = 1.6 E

Hence, D/(E+D) = 0.615    and,    E/(E+D) = 0.3846

Kd = 8%, Tax = 23%, and ROE = 14.6%

EBITDA is constant.

Now, we know that ROE = Not Income/Equity

or, Total Equity = Net Income/ROE = 2000000/.1460 = 13698630.14

Now, to find out the Firm value, we will us the formula of

Firm Value = Operating Free Cash Flows
                       (1+WACC)

let's calculate WACC first.

WACC = E/(E+D) * Re + D/(D+E) * Rd * (1-Tax)

all the data has been give or been calculated above, except for Re. Now since that is not given and we are unable to use CAPM here, we will consider the ROE to be Re. Using the values, we arrive at the answer of

WACC = 9.4%

Now, Operating free Cash Flow is = FCFF here.

FCFF = Net income + New Debt

To find out the amount of new debt, we use D/E = 1.6 and the Equity = 13698630

Hence, FCFF = 23917808

Hence, the Firm Value = 23917808/(1+9.4) = 23,891,918 (ANSWER)

Hope this helps. Goodluck!

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