Financial Strategy Questions. Accounting, Finance, SPSS Case Study

Corporate Financial Strategy (FINA-4740-91)
Midterm exam #1
Assumptions and definitions:
Marginal tax rate: 40%
Debt beta: 0.00
Risk-free rate: 4.93%
EMRP: 5%
Cost of debt: 6%
Target D/V ratio: 20%
Terminal growth rate (after 2011): 2.78%
t = 0: year 2006
NWC = Current assets (including cash and equivalents) – current liabilities
Problems:
1 Estimate unlevered free cash flows each year from 2007 to 2011, using Liedtke’s base case projections (Exhibits 6 & 7). (8 marks)
Free Cash Flow for the 2007 to 2011 period can be found using the FCF Formula, to wit:
FCF=EBIT 1-t+Depreciation-Capital Expenditures-Change in Net Working Capital
Accordingly, the values for these are found by;
* Change in NWC = Current Assets – Current Liabilities
* Capital Expenditures & Depreciation = from exhibit no. 6
* Changes in WC = from exhibits no. 7 and no. 4
Using excel to plug in the data, the resulting FCFF for the period is
YEAR

2007

2008

2009

2010

2011

TOTAL REVENUE

$ 479,329.00

$ 489,028.00

$ 532,137.00

$ 570,319.00

$ 597,717.00

Operating Expenses

$ (423,837.00)

$ (427,333.00)

$ (465,110.00)

$ (498,535.00)

$ (522,522.00)

Corporate Overhead

$ (8,487.00)

$ (8,659.00)

$ (9,422.00)

$ (10,098.00)

$ (10,583.00)

EBIT

$ 47,005.00

$ 53,036.00

$ 57,605.00

$ 61,686.00

$ 64,612.00

Taxes

$ (18,802.00)

$ (21,214.00)

$ (23,042.00)

$ (24,674.00)

$ (25,845.00)

Depreciation

$ 9,587.00

$ 9,781.00

$ 10,643.00

$ 11,406.00

$ 11,954.00

Capital Expenditure

$ (11,983.00)

$ (12,226.00)

$ (13,303.00)

$ (14,258.00)

$ (14,943.00)

CWC

$ (11,084.00)

$ (2,614.00)

$ (9,434.00)

$ (8,359.00)

$ (5,998.00)

Free Cash Flow

$ 14,723.00

$ 26,763.00

$ 22,469.00

$ 25,801.00

$ 29,780.00

2 Why is there no deduction of interest expense in Question (1)? Does EBIT(1-t) overstate the tax burden? (8 marks)
The resulting FCFF in Question No. 1 does not include the interest expense because the very concept of Free Cash Flow refers to the amount of cash that are available to the owners and creditors of the business. Hence, adding the interest expense, which is considered as a savings after tax could cause double computation when the tax expenses are already computed.
3 Estimate the firm’s WACC. What is the upper bound for the firm’s WACC? (10 marks)
In order to estimate WACC of the company, it is necessary to initially determine the unlevered COE. Using the CAPM Model and assuming the long-term horizon (20 years) the unlevered and levered WACC are as follows:
Unlevered CoE

D/E

D/(D+E)

CoD

Asset Beta - Debt Beta

CoE

E/(D+E)

WACC (unlevered)

Tax Rate

WACC (levered)

11.3%

0

0%

6.0%

5.0%

11.30%

100%

11.330%

40.000%

11.300%

11.3%

0.11

10%

6.0%

5.0%

11.90%

90%

11.330%

40.000%

11.100%

11.3%

0.25

20%

6.0%

5.0%

12.70%

80%

11.330%

40.000%

10.900%

11.3%

0.33

25%

6.0%

5.0%

13.10%

75%

11.330%

40.000%

10.700%

11.3%

0.67

40%

6.0%

5.0%

14.90%

60%

11.330%

40.000%

10.400%

11.3%

1.00
...