Question

Lockheed Corporation reported EBITDA of $4,000 million in the year just ended (year 0), prior to interest expenses of $1,000 million and depreciation charges of $600 million. Capital expenditures in the year just ended amounted to $1,000 million, and working capital was 8% of revenues (which was $20,000 million). The tax rate for the firm was 40%.

The firm had debt outstanding of $18.00 billion (in book value terms), trading at a market value of $20.0 billion and yield a pre-tax interest rate of 8%.

There were 100 million shares outstanding, trading at $250 per share, and the most recent beta was 1.20. The Treasury bond rate was 3%, and the market risk premium was 6.5%.

The firm expected revenues, earnings (EBITDA) and depreciation to grow at 10% a year from the current year (year 0) to year 3, after which the growth rate was expected to drop to 3% a year forever.

Capital expenditures will also grow at 10% a year from year 0 to year 3, but capital spending will be 120% of depreciation in the steady state period. The company also planned to lower its debt/equity ratio to 60% for the steady state which will result in the pretax interest rate dropping to 6%. As a result of the lowering of the firm’s debt/equity ratio, the beta of the firm is also expected to decline.

1. Estimate the free cash flow to the firm.

	Year 0	Year 1	Year 2	Year 3	Year 4
Growth Rate	10%	10%	10%	10%	3%
EBITDA	4,000
Depreciation	600
EBIT	3,400
Taxes	1360
EBIT(1-T)	2,040
Capital Expenditures	1,000
Revenues	20,000
Working Capital Required	1,600
Change in Working Capital	-1,600
Free Cash Flow to Firm

2. Compute the beta of the firm after Year 3.

3. Determine the Cost of Equity and WACC for the Period from Year 0 to Year 3, and the Cost of Equity and WACC after Year 3.

Cost of Equity Before Year 3 =

WACC Before Year 3 =

Cost of Equity After Year 3 =

WACC After Year 3 =

Answer 1

As per the given information:-

Market value of Debt = $20 billion

Market value of Equity = 100 million shares *$250 /share = $25 billion

Pre-tax Cost of Debt = 8%

Cost of equity = Riskfree rate+ beta * market risk premium = 3%+1.2*6.5% = 10.80%

So, WACC before year 3 = 20/(20+25)*8%*(1-0.4) + 25/(20+25)*10.80% = 8.1333%

After year 3,

D/E= 0.6

pretax cost of Debt =6%

Unlevered beta = 1.2/(1+(1-0.4)*20/25) = 0.810811

So, new levered beta = 0.810811* (1+(1-0.4)*0.6) = 1.102703

So, beta of the firm after year 3 = 1.102703

Cost of equity after year 3 = 3%+6.5%*1.102703 =10.16757%

So, WACC after year 3 = 0.6/1.6*6%*(1-0.4)+1/1.6*10.16757% = 7.7047%