Question

Problem #1 Free Cash Flow Model

ABC Company has an equity beta of 1.72 and a tax rate of 35%. What is the asset beta if the debt to equity ratio is 40%?

Using the answer from above, calculate the discount rate if the risk free rate is 2.75% and the market risk premium is 6.15%?

ABC Company had an EBIT last year of $15.6 million. Depreciation expense was $1.45 million. In other areas, ABC spent $1.75 million on capital expenditures and increased working capital by $0.865 million. What is ABC's Free Cash Flow for the year?

Using the information derived above, value ABC company assuming its FCF is expected to grow at a rate of 4.8%.

Answer 1

asset beta = equity beta*[1/1+(1-tax rate)*(debt to equity ratio)] = 1.72*[1/1+(1-0.35)*(0.40)] = 1.72*[1/1+(0.65*0.40)] = 1.72*[1/(1+0.26)] = 1.72*(1/1.26) = 1.72*0.7936507936507937 = 1.365 or 1.37

discount rate = risk-free rate + asset beta*market risk premium = 2.75% + 1.37*6.15% = 2.75% + 8.4255% = 11.175 or 11.76%

Free Cash Flow for the year = EBIT*(1-tax rate) + Depreciation expense - capital expenditures - increase in working capital

Free Cash Flow for the year = $15.6 million*(1-0.35) + $1.45 million - $1.75 million - $0.865 million = $10.14 + 1.45 - 1.75 - 0.865 = $8.975 million

Depreciation expense is a non-cash expense. so, it has been added back for free cash flow calculation.

Value of ABC company = Free Cash Flow for the year*(1+FCF growth rate)/(discount rate - FCF growth rate)

Value of ABC company = $8.975 million*(1+0.048)/(0.1176 - 0.048) = $8.975 million*1.048/0.0696 = $9.4058 million/0.0696 = $135.14 million