$9-4$ Enterprise Valuation$$Traditional WACC Model Canton Corporation is a privately owned firm that engages in the production and sale of industrial chemicals, primarily in North America. The firm$$s primary product line consists of organic solvents and intermediates for pharmaceutical, agricultural, and chemical products. Canton$$s managers have recently been considering the possibility of taking the company public and have asked the firm$$s investment banker to perform some preliminary analysis of the value of the firm$$s equity.

To support its analysis, the investment banker has prepared pro forma financial statements for each of the next four years under the $($simplifying$)$ assumption that firm sales are flat $($i$.$e$.,$ have a zero rate of growth$),$ the corporate tax rate equals $30\%,$ and capital expenditures are equal to the estimated depreciation expense.

Pro Forma Income Statements $($$$000)$

$1234$

Sales $ $100,000$ $ $100,000$ $ $100,000$ $ $100,000$

Cost of goods sold $(40,000)(40,000)(40,000)(40,000)$

Gross profit $$60,000$ $$60,000$ $ $60,000$ $ $60,000$

Operating expenses $($excluding $$depreciation$)(30,000)(30,000)(30,000)(30,000)$

Depreciation expense $(8,000)(8,000)(8,000)(8,000)$

Operating income $($earnings before $$interest and taxes$)$ $$22,000$ $ $22,000$ $ $22,000$ $$22,000$

Less: interest expense $(2,000)(2,000)(2,000)(2,000)$

Earnings before taxes $$20,000$ $ $20,000$ $ $20,000$ $$20,000$

Less: taxes $(6,000)(6,000)(6,000)(6,000)$

Net income $ $14,000$ $$14,000$ $ $14,000$ $$14,000$

In addition to the financial information on Canton, the investment banker has assembled the following information concerning current rates of return in the capital market:

The current market rate of interest on ten$-$year Treasury bonds is $7\%,$ and the market risk premium is estimated to be $5\%.$

Canton$$s debt currently carries a rate of $8\%,$ and this is the rate the firm would have to pay for any future borrowing as well.

Using publicly traded firms as proxies, the estimated equity beta for Canton is $1\mathrm{.}60.$

What is Canton$$s cost of equity capital? What is the after$-$tax cost of debt for the firm?

Calculate the equity free cash flows for Canton for each of the next four years. Assuming that equity free cash flows are a level perpetuity for year $5$ and beyond, estimate the value of Canton$$s equity. $($Hint: Equity value is equal to the present value of the equity free cash flows discounted at the levered cost of equity.$)$ If the market rate of interest on Canton$$s debt is equal to the $8\%$ coupon, what is the current market value of the firm$$s debt? What is the enterprise value of Canton? $($Hint: Enterprise value can be estimated as the sum of the estimated values of the firm$$s interest$-$bearing debt plus equity.$)$

Using the market values of Canton$$s debt and equity calculated in Problem $9-5($b$),$ calculate the firm$$s after$-$tax weighted average cost of capital. Hint:

$$

WACC

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Cost$$of

$$

Debt

$$

$($

$1$

$$

Tax

$$

Rate

$)$

$$

$($

Debt$$Value

Enterprise$$Value

$)$

$+$

Cost$$of

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Levered$$Equity

$$

$($

Equity$$Value

Enterprise$$Value

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What are the FCFs for Canton for years $1$ through $4?$

Estimate the enterprise value of Canton using the traditional WACC model. Base your estimate on your previous answers, and assume that the FCFs after year $4$ are a level perpetuity equal to the year $4$ FCF$.$ How does your estimate compare to your earlier estimate using the sum of the values of the firm$$s debt and equity?

Based on your estimate of enterprise value, what is the value per share of equity for the firm if the firm has $2$ million shares outstanding? Remember that your calculations up to this point have been in thousands of dollars.