Chapter 7:

Risk free
i. rf = YTM – default spread
ii. rf = YTM safest corporate bond – default spread
iii. Forward rate Foreign currency, $ = Spot Rate Foreign currency [(1 + rf ) / (1+
FC

rf $)]n

rf FC = …..

iv. rf local = (1+ rMature) * [(1+ inflocal)/(1+ infMature)] - 1

v. Buildup approach: rf = expected inflation + expected growth

Use i. or iv.
DS = YTM risky bond – YTM rf bond (in the same currency with the
same maturity)

Beta
βL = βU [1 + (1 – Tax rate) (MV Debt / MV Equity)]
1. Unlever sectors
a. In Firm Value/Sales case:
Sales = Revenue * Firm Value then we can get the weights
and βU
2. βUcompany=weighted average
3. Lever the Beta
Business risk = βU / βL

βUadjusted for cash = Unlevered Beta / [1- (Cash / Firm Value)]

EV/Sales ratio case: Sector value = EV/Sales ratio * Revenue of sector

Unlevered beta for industry = Unlevered Beta/ (1+ FC/ VC)

Special dividend effect on Beta: Chrysler, the automotive manufacturer, had a

beta of 1.05 in 1995. It had $13 billion in debt outstanding in that year, and 355
million shares trading at $50 per share. The firm had a cash balance of $8
billion at the end of 1995. The marginal tax rate was 36%.

a. Estimate the unlevered beta of the firm = 1.05/(1+(1-.36)(13000/355*50)) =

0.715
Unlevered beta of non-cash assets = 0.715/(1- 8000/(13000 + 355*50)) = 0.966
b. Estimate the effect of paying out a special dividend of $5 billion on this
unlevered beta.
Value of Firm after cash dividend = 13000 + 355*50 – 5000 = 25750
New unlevered beta = 0.966 (22750/25750) + 0 (3000/25750) = 0.85
c. Estimate the beta for Chrysler after the special dividend.
The debt ratio would be rise to 13000/(355x50-5000). The levered beta is
0.85(1+(1-0.36)(13000/(355x50-5000))) = 1.41

Beta of cash example:

The stock is currently trading at $ 40 per share, and there are 250 million
shares outstanding; the firm has no debt outstanding. InfoSoft also has $ 2
billion in cash that it has accumulated over time. The average beta for
entertainment software firms is 1.50, and that the average debt/equity ratio of
these firms is 10%. (You can assume that the cash balances at these firms are
negligible and that the marginal tax rate is 40% for all firms) Estimate InfoSoft's
current beta.

βU sector = 1.42
βCompany = wEq * βU sector + wCash * 0 = 1.13

ERP and RP Country

Total ERP = RPMature + RPCountry
 RPCountry = ERPCountry – ERPUS
 RPCountry = default spread * (deviationequity/deviationbonds) [melded
country risk premium approach]
o Default spread = Mexican dollar bond rate – US bond rate
 ERPCountry = RPUS * (deviationUS/deviation Country)
 ERPSector= weight of revenues in US * ERPUS + weight Brazil *
ERPBrazil
o CoESector = rf + B * ERPSector
 Implied ERP
o Index price = [Dividend * (1+g)] / (r-g)
o Implied ERP = (D1 + Price*g) / Price
o Implied ERP = r – bond rate
o Can be used as ERP that is multiplied by Beta in CoE
calculation
Example: You have been asked to assess the implied risk
premium on the Timbuktu Stock Exchange (TSE). The index
is trading at 1050, and the dividend yield is 3%. The current
long term bond rate is 6.5%, and the expected long term
nominal growth rate in the economy is 6%. Estimate the
implied risk premium for equities. Answer: 1050 = 31.50
(1.06)/(r-.06) r = 9.18% Implied ERP = 9.18 – 6.5 = 2.68%

CoE:
 Approach 1: Constant exposure to CRP, Location CRP
o COE = rf + β * ERPUS + RPcountry
 Approach 2: Constant exposure to CRP, Operation CRP
 o COE = rf + β * ERPUS +(% of rev * RPCountry + % of rev *
RPUS/0)
 Approach 3: Beta exposure to CRP, Location CRP
o COE = rf + β * (ERPUS + RPcountry)
 Approach 4: Beta exposure to CRP, Operation CRP
o COE = rf + β * (ERPUS + (% of rev * RPCountry + % of rev *
RPUS/0)
 Approach 5: Lambda exposure to CRP
o COE = rf + β * ERPUS + λ * RPCountry
 λ = % of revenue of firm / % of revenue for an average firm
 COECountry = (1+ COEMature) * [(1+ infCountry)/(1+ infMature)] - 1 (CAN
ALSO BE USED FOR CC)

Problems:
1. Savoy Inc. is a company based in Indonesia, with substantial interests in the
hotel/tourism business and in forest products.
Business Operating Income Unlevered Beta of
comparables
Hotel/Tourism 60% 1.25
Forest Products 25% 0.80
Cash 15%

Debt to equity ratio of 150%. default spread for B- rated bonds is 3%, and the
Indonesian equity index is three times more volatile than the Indonesian long
term bond.
Estimate the cost of equity for this firm in U.S. dollar terms, if the treasury bond
rate is 5%. (The tax rate for the firm is 30%, and the historical risk premium in
the US is 6%)

1. BU Weighted average = 60% * 1.25 + 25% * 0.8 + 15% * 0 = 0.95

BL = 1.9475
2. Approach 3: CoE = 5% + 1.9475 * (6% + [3%*3]) = 0.3425

IMPORTANT: Chimera Corporation is in two businesses – soft drinks and

consumer products, and has operations in two countries – the United States and
Mexico. The firm had operating income of $ 1.5 billion on its US operations,
with 60% coming from soft drinks and 40% from consumer products,
1 billion from its Mexican operations, with 50% from soft drinks and 50% from
consumer products.
The unlevered beta for soft drink firms is 0.7 and the unlevered beta for
consumer products is 0.9.
Mexico is rated BB, the default spread is 3.8% for BB rated countries and the
Mexican equity index is twice as volatile as the Mexican long term bond.
Assuming that this firm has no debt outstanding, estimate the cost of equity for
the firm in US dollar terms. The treasury bond rate is 6.5% and the market risk
premium for the US is 6%. You can assume that value is proportional to
operating income, and that beta also measures exposure to country risk ( 4
points)
a. Estimate the unlevered beta for the firm
EBITsoft drinks = 60% * 1.5 + 50% * 1 = 1.4
EBITproducts = 40%*1.5 + 50%*1 = 1.1

βU = wsoftdrinks * βU sector + .. = 0.788

b. Estimate the cost of equity for the US operations.

COEUS ops = 6.5% + (60%*0.7 + 40%*0.9) * 6% = 11.18%

c. Estimate the cost of equity for the Mexican operations.

Approach 3: CoEMexico ops = 6.5% + 0.8 * (6% + [3.8%*2]) = 17.38%

CoD
i. Pre-tax cost of debt: = T-Bond rate or risk free + default
spread
a. If company exposed to risk of two countries or more: rfeuros
+ default spread company + λ default spread Poland + λ
default spread hungary. (weighted average can be done)
b. use interest coverage ratio to get synthetic rating = (EBIT +
Op lease expense) / (Interest expense + Op lease expense)
ii. After tax cost of debt = pre-tax * (1-marginal tax rate) [NOT
effective tax rate]

MV Debt:
Market value of interest bearing debt = PV of Interest payments + PV of
FV or BVDebt + PV of lease commitments
 PV of Interest Payments = (face value * IR of loan) discounted Pre-
tax CoD or IR of rated bond not the IR of loan. N=5 PMT=
Interest payments IR=.. compute PV
 PV of face value or BV of debt N=5 PMT= 0 IR=.. compute PV
 PV of lease commitments
 N can be equal to weighted average of maturity

MV Equity:
If there is a convertible bond:
MV Equity = 100
The company has one convertible bond, with a face value of $ 100
million, a ten-year maturity and a coupon rate of 2%; the bond has a
market value of $120 million.
I pre-tax cost of debt is 5%,
Answer:
Straight bond (debt) = $2 million (PV of annuity for 10 years @5%) +
$100 million/1.0510 = $76.83
Conversion option (equity) = MV Convertible – Straight bond = $120 -
$76.83 = $43.17
Overall value of equity = $143.17 million

If there is preferred stock:

i. PS = Div / Price [If dividends paid quarterly rPS = (1+r)4 - 1, If
dividends is paid semiannually r = (1+r)2 – 1]
ii. WACC = rE [MV E / (MV E + MV D + MV PS)] + rD(1 - T)[MV D /
(MV E + MV D + MV PS)] + rPS [MV PS / (MV E + MV D + MV PS)

Cost of capital:
CC = Weight of MV Equity * CoE + Weight of MV Debt * Pre-tax CoD *
(1-Marginal tax)

Chapter 9
Converting R&D to equity:
Adjusted BV Equity = BV Equity + Value of research asset
Adjusted operating income = Operating income + R&D expenses – amort
of research asset
Adjusted Net income = NI + R&D exp - amort

Converting Operating leases into debt:

i. Adjusted Debt = BV Debt + PV of lease commitments (at pre-tax
CoD)
ii. Adjusted EBIT = EBIT + Op. lease exp – Dep of lease (this year’s.
Can assume straight-line)
iii. Or: = EBIT + Debt Val of Op. lease exp * interest rate on
debt

Chapter 10:
FCFF:
FCFF = Adjusted EBIT *(1- tax rate)– Reinvestment – Adjusted Net
CAPEX - ∆NWC

Adjusted EBIT:
 i. Adjusted EBIT for R&D = After-tax operating earnings +
Current R&D expense – Amortization R&D asset
a. Amortization: (take the sum of the amortized amount of each
year’s expense. If three years prior then use 1/3 as a rate of
each year’s expense.)
i. Add tax benefit to FCFF = (Current R&D expense –
Amortization) * tax rate
ii. Adjusted EBIT for lease commitments =
old EBIT + current lease expense – Depreciation of lease commit
a. Depreciation = PV of Leases / number of years

iii. Adjusted EBIT for lease commitments = old EBIT + pre-tax CoD
x PV of lease comm (at pre-tax CoD)

iv. If company has negative net income then no after tax

adjustment
EBIT = Net Income + Interest expenses
v. EBIT = EBITDA – Depreciation – Amort

Tax rate:

a. Effective = Taxes due / Taxable income.

i. Taxable income = EBIT – Interest Expenses
b. Marginal = tax rate the firm faces on its last dollar of income.
This rate depends on the tax code and reflects what firms
have to pay as taxes on their marginal income
Net operating losses situation
You are valuing TeleTech, a small software company that is on the verge of
becoming profitable. The company has net operating loss carried forward (from
prior years) of $ 2 million, is expected to report an operating loss of $ 1 million
next year and then an operating profit of $ 5 million in year 2. What is the
aftertax operating income for Teletech in year 2, if the tax rate is 40%?
Answer:
NOL in year 2 = $ 2 million + $1 million (loss in year 1) = $3 million
Operating income in year 2 = $ 5 million
Taxable income in year 2 = $ 5 million - $ 3 million = $ 2 million
Taxes = $ 2 million * .4 = $0.8 million
After-tax operating income = $5 million - $0.8 million = $4.2 million

Reinvestment:

Reinvestment = Reinvestment rate * After-tax adjusted EBIT

 Reinvestment rate = Growth / RoC

 o RoC = after-tax adjusted EBIT / (MV Debt+Equity)

Adjusted Net CAPEX

Adjusted Net CAPEX = Adjusted CAPEX – Adjusted dep and amort

 Adjusted CAPEX = CAPEX + current R&D expense + Acquisitions
(in cash + in stock)
 Adjusted dep and amort = Dep + amort of R&D asset

Non-cash Working Capital:

NCWC = Working Cap – Cash + short-term debt

∆NCWC = This year – last year’s – Cash Increase + Cash Decrease

Problem 3:
earnings before interest and taxes of $60 million last year,
operating lease expenses of $50 million last year and has a commitment to
make equivalent payments for the next eight years.
capital expenditures of $30 million and depreciation of $50 million last year.
two acquisitions, one funded with cash for $50 million and another funded with
a stock swap for $30 million. The amortization of these acquisitions is already
included in the current year's depreciation.
The total working capital increased from $180 million at the start of the year to
$200 million at the end of the year. However, the firm's cash balance was a
significant portion of this working capital and increased from $80 million at the
start of the year to $120 million at the end. (The cash is invested in T-bills.)
The tax rate is 40%, and the firm's pretax cost of debt is 6%.
Estimate the free cash flows to the firm last year.
Answer:

FCFF = After-tax adjusted EBIT + Depreciation – CAPEX – Change in NCWC:

After-tax adjusted EBIT = Adjusted EBIT lease commit * (1-Tax) =(old EBIT +
CoD * PV lease commit) * (1-T) = (60 + 6%*310.49) * 0.6 = 47.18

+ Depreciation 50

- Adjusted CAPEX 30+50+30 = 110

- Change in NCWC 200-180-40 = -20

FCFF = 7.18

Problem 2:
The firm reported $80 million in earnings before interest and taxes, capital
expenditures of $30 million, and depreciation of $20 million in the most recent
year.
The firm had R&D expenses of $50 million in the most recent year. You believe
that a threeyear amortizable life is appropriate for this firm and the R&D
expenses for the past three years have amounted to $20 million, $30 million,
and $40 million respectively.
The firm also made two acquisitions during the year—a cash-based acquisition
for $45 million and a stock-based acquisition for $35 million. If the firm has no
working capital requirements and a tax rate of 40%,
estimate FCFF of most recent year

Answer:

FCFF = After-tax adjusted EBIT– Adjusted NetCAPEX - ∆NCWC

Adjusted EBIT for R&D = After-tax operating earnings + Current R&D expense
– Amort R&D asset = 80 * 60% + 50 – 30 = 68

+ Depreciation = 20

+ Amortization = 30

Adjusted CAPEX = CAPEX + current R&D expense + Acquisitions (in cash +

in stock)
= 30 + 50 + 45 + 35 = 160
FCFF = -42

∆NCWC:
total working capital increased from $100 million last year to $120
million this year.
last year’s cash balance had $ 30 million in cash and $15 million in short
term debt
this year’s cash balance has $20 million in cash and $25 million in short
term debt.
What effect did working capital have on your cash flow this year?
Answer:
Non-cash WC last year = 100 – 30 +15 = 85
Non-cash WC this year = 120 -20 + 25 = 125
Change in non-cash WC = 125 – 85 = +40 (Decreases CF)

∆NCWC: generated $20 million in after-tax operating income on

revenues of $100 million during the course of the most recent year. You
expect revenues to grow 10% a year next year and margins to stay
stable.

The firm’s non-cash current assets are $40 million and its non-debt
current liabilities are $50 million, and non-cash working capital as a
percent of revenues is expected to remain unchanged next year.
If the net cap ex is expected to be $10 million next year, what is your
estimate of the FCFF for the next year?

Answer:
Non-cash WC = 40 -50 = -10
Non-cash WC as percent of revenues = -10/100 = -10%
Expected revenues next year = $110 million
Expected non-cash WC = -$11 million
Change in WC = -10-(-11) = 1
 FCFF = 20 (1.10) - $10 +1 = $13 million

FCFE:
FCFE = NI + Depreciation - CAPEX - ∆NCWC + New Debt – Debt
Repayment

FCFE = NI – (CAPEX – Depreciation)(1-δ) – (∆NCWC)(1-δ)

 δ = MV Debt / (MV Debt + MV Equity)

FCFE = NI + Current R&D expense – Depreciation R&D asset +

Noncash expense –Noncash revenues – (CAPEX + Current R&D expense
– Depreciation – Depreciation of R&D asset) - ∆NWC + New debt issued –
Debt repayment + New preferred stocks issued – Preferred shares
bought back
Example: In the most recent year, which was a bad one, the company made only
$ 40 million in net income. It expects next year to be more normal. The book
value of equity at the company is $ 1 billion, and the average return on equity
over the previous 10 years (assumed to be a normal period) was 10%. The
company expects to make $ 80 million in new capital expenditures next year. It
expects depreciation, which was $ 60 million this year, to grow 10% next year.
The company had revenues of $ 1.5 billion this year, and it maintained a non-
cash working capital investment of 10% of revenues. It expects revenues to
increase 20% next year and working capital to decline to 9.5% of revenues. The
firm expects to maintain its existing debt policy (in market value terms). The
market value of equity is $ 1.5 billion and the book value of equity is 500
million. The debt outstanding (in both book and market terms) is $ 500 million.

Answer:

NI = 1000 * 10% = 100

(CAPEX-Dep)* (1-δ) = (80 – 66) * [1-(500/(500+1500))] = 10.5

(∆NCWC)(1-δ) = [9.5% * 1800 – 10% * 1500] * (1-0.25) = 15.75

FCFE = 73.75
From FCFF to FCFE:
FCFF of $50 million for firm for the most recent year.
Total debt decreased from $100 to $85 million during the course of the
year and it reported interest expense of $10 million for the year.
tax rate is 30%
FCFE?
Answer:
To get from FCFF to FCFE, you subtract out the after-tax interest
expense and the net debt change (if debt increases, it is a cash inflow
whereas a debt decrease is cash outflow).
FCFF – Interest expense (1-t) + Change in Debt = FCFE • 50 – 10 (1-.30)
-15 = $28 million

CHAPTER 11: GROWTH

I. Historical Growth Rate:

o Arithmetic = g1 + … + gN / N where g = (Rev 1 – Rev
0) / Rev 0
o Geometric = (Rev N / Rev 0) 1/n – 1
Revenue growth is less volatile than earnings growth and is much less
likely to be swayed by accounting adjustments and choices. Rather than
looking at average growth over the past few years, look at growth each
year. Use historical growth rates as the basis for projections only in the
near future (next year or two)

II. Fundamentals:
1) Earnings per Share

Stable ROE:

gEPS = ROE * Retention Ratio

 Retention ratio = 1 – Payout ratio OR Retained earnings last

year / NI last year
Payout ratio = Dividends / NI
 ROE = NI / BV equity

Changing ROE:

gEPS = ROEt+1 * Retention ratio + [(ROEt+1 – ROE) / ROE]

2) Net income
Stable ROE:

gNI = ROE * Equity reinvestment rate

 Equity reinvestment rate = (CAPEX – Depreciation + ∆NWC – debt
issued + debt repaid) / NI. Can be >100 unlike retention ratio
and excess is funded with new equity
 ROE = NI / BV equity
OR: ROE = ROC + D/E * (ROC – Int expense*(1-T))
o ROC = After-tax EBIT / (BV Debt + BV Equity – Cash)

Comment: If non cash growth then:

 ROE = (NI – after-tax interest income) / (BV equity – Cash)

Changing ROE:

gNI = ROE * Equity reinvestment rate + [(ROEt+1 – ROE) / ROE]

CHECK DELTA

3) EBIT

Stable ROC:

g EBIT ROC * Reinvestment rate

=
 Reinvestment rate = [CAPEX – Depreciation+ ∆NCWC] / [EBIT(1-
T)]
 ROC = After-tax EBIT / (BV Debt + BV Equity – Cash)

Changing ROC:

g EBIT = Reinvestment rate x ROC now + Efficiency growth

Efficiency growth = [(ROCt+1 – ROC) / ROC]

gCAGR = Reinvestment rate x ROC now + [(1+efficiency growth)1/n-1]

Negative Earnings:

grevenues:
 Determine the total market (given your business model) and
estimate the market share that you think your company will earn.
 Decrease the growth rate as the firm becomes larger
 Keep track of absolute revenues to make sure that the growth is
feasible
Operating margins:
  Set a target margin that the firm will move towards
 Adjust the current margin towards the target margin

Reinvestment Needs using sales to capital ratio:

 Capital gains = (New – Old) / Old (POST CLASS 9 Q5)

 When we have % like capital gains use this for growth: g = (1 +
CG)1/n – 1
 When we have a ratio like GDP1/GDP0 use this for growth:
g = (X1/X0)1/n – 1

MCQ:

You are trying to estimate the free cash flow to the firm for FormaWare, a
young, money losing company with significant growth potential. The
company generated a loss of $10 million on revenues of $100 million in
the most recent year but is expected to double revenues next year, while
halving its operating losses. If the company has a sales/capital ratio of
4.0, what is the FCFF next year?

Answer: Expected Operating income next year = -$5 million (no taxes)
Change in revenue next year = $200 m - $100 m = $100 m Reinvestment
next year = $100 m/4 = $25 million FCFF next year =- $5 m - $25 m = -
$30 million

 ROC = [EBIT (1-T)] / [BV(D+E)]

 ROE = NI / BV (E)

 ROC with OL and R&D = [(EBIT + Current OL – Depreciation of OL)(1-T)

+ Current R&D expense – Depreciation R&D] / [BV (D) + PV of OL + BV
(E) + Value of R&D asset]

 ROE = [NI + Current R&D expense – Dep R&D asset] / [BV(E) + Value of
R&D asset]

CHAPTER 12: TERMINAL YEAR

 If the growth is high (>10%) we use a 3 stage model
 If the growth is medium (greater than rf but less than 10%) we use
a 2 stage model
 If g = rf forever, we use 1 stage model
 Use effective tax rate for years preceding the terminal year

FCFF Model
FCFF year 1 = After-tax EBIT * (1-Reinvesment Rate)
o Reinvestment rate = g / RoC
 RoC = After-tax EBIT / Capital
FCFF year 2 = [FCFF year 1 * (1+g)] * (1-Reinvestment Rate)

Terminal Value = FCFF Terminal year / (CC – g)

 FCFF Terminal year = [FCFF year 3 * (1+g)] * (1-Reinvesment

Rate)
o Reinvestment rate terminal = g terminal / ROC terminal = rf long
term / WACC terminal

Equity Value = SUM of PVs of FCFFs + Cash – Debt

 SUM of PVs = PV FCFF 1 at CC + … + PV FCFF year 3

o PV FCC year 3 = (FCFF year 3 + Terminal Value) / (1+CC)3

COMMENTS:
 g terminal = rf long-term
 ROC terminal = WACC terminal
 Use the Marginal Tax Rate

Apply your judgment for WACC assumptions terminal year

o β < 0.8, then push it to 0.8

o β > 1.2, then push it to 1.2
o 0.8 < β < 1.2 => β =1
o rp = average geometric historical rp
o CRP (Try to improve CRP)
o rD = Investment grade rating: BBB and above (push it a grade up)
o weights for WACC: Industry weights

PROBLEMS:

a. Value the equity in the company today, with its operating mix
intact, assuming that both divisions will grow 3% a year forever,
while maintaining their current returns on invested capital.

Value of pharma business = FCFF / [CC-g]

  FCFF = After-tax EBIT * (1 - Reinvestment Rate)
o Reinvestment Rate = g / RoC
 After-tax EBIT/Invested Capital
 CC =8.32% (CoE * w + After-tax CoD * w)
 G = 3%

FCFF = 90 * [ 1 - (3%/(90/900)) ] = 63

 Value of pharma = 63 / (8.32%-3%) = 1184.21

 Value of Cosmetics = 90* [1- (3% / (120/1000)) ] / (9.76%-

3%) = 1331.36

Equity Value = 1184+1331 - 1200 = 1315.57

b. Now assume you plan to sell the pharmaceutical business for

$1.2 billion and use the proceeds to pay off all its debt. After the
divestiture, the company will be able to raise cosmetics prices,
thus increasing the after-tax operating margin to 15% for that
business. Assuming that the growth rate remains 3%, estimate the
value of equity in the company after the sale.

Invested Capital = 900 + 1000 - 1200 = 700

Equity Valueafter divesting = FCFF next year / [CoE Cosmetics – g ]

FCFF next year = [1000*15%] * [ 1 – ( 0.03 / (150/700)) ] = 129

CoE Cosmetics:
BU = 1.92/ (1+ 0.6???? * 1200/1315.57) = 1.24
CoE = 3% + 1.24 * 6% = 10.44%

Equity Valueafter divesting = 129 / (10.44% - 3%) = 1732.64

a. Assume that you want to be oil price neutral, i.e., value the
company given the oil price today. If you expect the oil-price
neutral earning to grow 6% a year for the next three years, while
maintaining this normalized return on capital, estimate the free
cash flows to the firm for the next three years.

YEAR 1:
After-tax EBIT = (100 + 50*70 ) * (-0.25 + 0.005 * 70) = 360
Reinvensmnt rate = g / (after-tax EBIT / Capital )
= 6% / (360/(1800+100+800)) = 33.33%

FCFF year 1 = After-tax EBIT * (1-Reinvesment Rate) = 240

FCFF year 2 = [FCFF year 1 * (1+g)] * [1-Reinvestment Rate] = 240
*1.06 * (1-33.33%) = 381.6
FCFF year 3 = [FCFF year 2 * (1+g)] * [1-Reinvestment Rate] = 404.5 *
(1-33.33%) = 269.66

b. After year 3, the company expects the business to be in secular

decline and operating earnings to decline 3% each year in
perpetuity. If you assume that the company will be able to sustain
its return on capital in perpetuity, estimate the terminal value (at
the end of year 3).

Terminal Value = [FCFF year 3 * (1+g)] * (1-Reinvesment Rate) / (CC –

g)

o Reinvestment rate = (-3%/(360/2000)) = -16.67%

Terminal Value = [404.5*(1 + (-3%))] * [ 1 – -16.67%] / ( 0.1 – (-3%)) =

457.75 / ( 0.1 – (-3%)) = 3521.2

c. Estimate the value per share today, if there are 100 million
shares outstanding.

Equity Value = PV of FCFFs and Terminal Value + CASH - DEBT

PV FCFF 1 = 240 / (1.10)^1 = 218.18

PV FCFF 2= 254.4 / (1.10)^ 2 = 210.25
PV FCFF 3 = (FCFF year 3 + Terminal Value) / (1.10)^3 = (269.66 +
3521) / 1.103 = 2848.12

Equity Value = 3276.55 (Sum) + 800 – 1000 = 3076.55

Value/Share = 3076.55/100 = 30.77

You are valuing GenFlex, a small manufacturing firm, which reported

paying taxes of $12.5 million on taxable income of $50 million and
reinvesting $15 million in the most recent year. The firm has no debt
outstanding, the cost of capital is 11%, and the marginal tax rate for the
firm is 35%. Assuming that the firm's earnings and reinvestment are
expected to grow 10% a year for three years and 5% a year forever after
that, estimate the value of this firm using the effective tax rate for the
next three years and the marginal tax rate in year 4.

First 3 years:

Effective tax rate = 12.5/50 = 25%

After-tax EBIT = 50*(1-0.25)= 37.5

After-tax EBIT of 37.5 grows at 10% until year 3

-Reinvestment of 15 grows at 10% until year 3
= FCFF of all 3 years
Get PV of each year’s FCFF using (1+CC)n

Terminal year:
Marginal tax rate = 35%
After-tax EBIT = 50*(1-0.35) = 32.5

EBIT (terminal year) = 32.5 * (1.1)3 * 1.05 = 45.42

-Reinvestment (terminal year) = 15 * (1.1)3 * 1.05 = 20.96
FCFF = 24.46
Terminal value = FCFF / (CC – g ) = 24.46 / 0.06 = 407.62
PV of Terminal value = 407.62 / (1.11)3 NOT 4

 SUM of PVs = Firm Value = 364.34