Question

XYZ Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years in millions of dollars: Items Revenues Costs of Good soles and operating expenses Depreciation Increase in net working capital Capital expenditures Marginal corporate tax rate Unlevered Net Income Year 1 106.5 47.7 25.9 3.1 29.1 40% 19.7 Year 2 159.9 59.9 35.5 7.6 43.8 40% 38.9 a. What are the free cash flows for this project for the first years and the second year? b. If the initial investment of the project is 10 thousand dollars and the cost of capital for this project is 15%, what is your estimate of the enterprise value? c. If XYZ has a debt of 5 thousand dollars and its number of shares outstanding is 2 thousand shares, what is the price of its stock?

Answer 1

Answer for XYZ Enterprise

a.) Calculating Free cash flows for Year 1 and 2

Concept - Free cash flow is the cash available to the shareholders or bondholders. In this case, since the company is unlevered the entire cash will be available to the shareholders.

Here we will calculate it as EBIT(1-t) then add back Depreciation (non cash expenses) and then subtract two expenses i.e Investment in Net Working Capital and Investment in Capex (figures taken from the Balance Sheet)

Year 1 Year 2 (in Mn Dollars)

EBIT (1-t) 19.7 38.9

+ Depreciation    29.5 35.5

- Change in Net Working Capital 3.1 7.6

- CapEx 29.1 43.8

Free Cash Flow   17 23

b.) To calculate Enterprise Value we discount the free cash flow with the given discount rate to bring those cash flows to present value. At the end of the projected period, we calculate a terminal value which is a figure with growth till perpetuity and discount that as well to bring it to present value and then add all the values.

	Yr 0	Yr 1	Yr 2	Terminal Value
Free cashflow	-0.01	17	23	[23(1+5%)]/(15%-5%) = 241.50
Discount Factor	1	0.87	0.76	0.76
Discounted Cashflow	-0.01	14.79	17.48	317.70

Therefore the estimated Enterprise Value is 349960 Thousand dollars.

Assumption: Here we have taken the perpetual growth rate to be 5%. This value can be changed accordingly to change the EV

c.) Enterprise Value = Market Value of Common Stock + Market Value of Debt - Cash and Cash Equivalents

Therefore, the market value of common stock is 349960 - 5000 = 344960 Dollars

Per-share value = 344960/2000 = 172.48 Dollars

Answer for 2 projects

a.) Calculating the above values in Excel using the NPV function we get the NPV of the projects. We choose the project with the higher NPV as it represents more economic benefit for the project. In this Project Alpha will be chosen due to higher NPV.

Yr Yr 1 Yr 3 Yr 4 Yr 5 Alpha Beta -80 -80 Yr 2 20 25 25 25 30 25 35 25 Disc. Rate PV of cashflows NPV 40 0.15 95.92 15.92 25 0.16 81.86 1.86

*** Answer 'for graph showing IRR' not completed as the question was not clear.

Answer for Stock of ABC Firm

Now we use Dividend Discount model to find out share price. i.e Dividend/K-g where K is the Cost of equity and g is the perpetual growth rate. So the answer is 4.43/0.12-0.05 = 63.28

Current Dividend Yr 1 Dividend 78*0.05 = 3.9 3.9*1.04 = 4.06 Yr 2 Dividend Yr 3 dividend 4.06*1.04 = 4.22 4.22*1.05 = 4.43

Therefore the stock price is overvalued at the current moment and should be sold at the current prices.

Answer for Capital Budgeting

Capital budgeting is used to make a decision on whether to undertake a project or not.

Sensitivity analysis showcases the effect of changes in sales, cost and other variables on the project value and the decision thereon. We can evaluate the project based on different assumptions bases on sales or cost etc. and change the values accordingly for each of them. The NPV changes for each of the cases and decision can be taken accordingly.

Scenario analysis gives the results based on changes in various factors at the same time. Suppose we consider 3 scenarios - Best, Base and Worst case scenario. We adjust sales, cost, discount factor, Interest cost etc. together in each of the 3 cases to come up with a result.

Therefore, the primary difference between the 2 is the fact that sensitivity takes into account a single parameter at a time and scenario considers multiple parameters together for a single scenario.