a. Estimate the target firm’s asset beta. (Round your answer to 2 decimal places.) b. Estimate the target’s unlevered, or all-equity, cost of capital (KA). (Round your answer to 1 decimal place.) c. Estimate the target’s all-equity present value. (Enter your answer in millions rounded to 2 decimal places.)
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
A group of investors is intent on purchasing a publicly traded company and wants to estimate the highest price they can reasonably justify paying. The target company’s equity beta is 1.20 and its debt-to-firm value ratio, measured using market values, is 60 percent. The investors plan to improve the target’s cash flows and sell it for 12 times
| ($ millions) | |||||||
| Year | 1 | 2 | 3 | 4 | 5 | ||
| Free cash flows | $33 | $48 | $53 | $58 | $ | 58 | |
| Selling price | $ | 696 | |||||
| Total free cash flows | $33 | $48 | $53 | $58 | $ | 754 | |
To finance the purchase, the investors have negotiated a $480 million, five-year loan at 8 percent interest to be repaid in five equal payments at the end of each year, plus interest on the declining balance. This will be the only interest-bearing debt outstanding after the acquisition.
| Selected Additional Information | ||
| Tax rate | 40 | percent |
| Risk-free interest rate | 3 | percent |
| Market risk premium | 5 | percent |
a. Estimate the target firm’s asset beta. (Round your answer to 2 decimal places.)
b. Estimate the target’s unlevered, or all-equity, cost of capital (KA). (Round your answer to 1 decimal place.)
c. Estimate the target’s all-equity present value. (Enter your answer in millions rounded to 2 decimal places.)
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