The top three members of the management team of an electronic firm purchased the

Question

The top three members of the management team of an electronic firm purchased the company with their own personal fund and $100 million borrowing. The interest on the loan was 11% and the loan is to be paid off annually by $25 million so that by the end of year 4 the loan will be fully paid off. The unlevered cost of equity for the firm is estimated at 12% and the tax rate is 35%. The free cash flows are estimated for the next four years as follows: $50 million in year 1, $55 million in year 2, $58 million in year 3, and $60 million in year 4. The cash flow is expected to grow at 3% per year after the fourth year.

Estimate the value of the firm as of year 0 using the APV valuation method.

Explanation / Answer

[$ in millions] 0 1 2 3 4 5-------> FCF 50.00 55.00 58.00 60.00 PVIF at 12% 0.89286 0.79719 0.71178 0.63552 PV at 12% 44.64 43.85 41.28 38.13 Sum of PV of FCF - t1 to t4 167.90 Continuing value of FCF = 60*1.03/(0.12-0.03) = 686.67 PV of continuing value = 686.67*0.63552 = 436.39 Unlevered value of FCF 604.30 Interest expense: Beginning loan balance 100.00 75.00 50.00 25.00 Tax shield on interest at 35% 35.00 26.25 17.5 8.75 PVIF at 11% 0.90090 0.81162 0.73119 0.65873 PV of interest tax shield 31.53 21.31 12.80 5.76 Sum of PV of ITS - t1 to t4 71.40 APV = 604.30+71.40 675.69

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