9-4 Enterprise ValuationTraditional WACC Model Canton Corporation is a privately owned firm that engages in the production and sale of industrial chemicals, primarily in North America. The firms primary product line consists of organic solvents and intermediates for pharmaceutical, agricultural, and chemical products. Cantons managers have recently been considering the possibility of taking the company public and have asked the firms investment banker to perform some preliminary analysis of the value of the firms 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. 348 chapter 9Enterprise Valuation Canton Corporation Financials Pro Forma Balance Sheets ($000) 0 1 2 3 4 Current assets $ 15,000 $ 15,000 $ 15,000 $ 15,000 $ 15,000 Property, plant, and equipment 40,000 40,000 40,000 40,000 40,000 Total $ 55,000 $ 55,000 $ 55,000 $ 55,000 $ 55,000 Accruals and payables $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 Long-term debt 25,000 25,000 25,000 25,000 25,000 Equity 25,000 25,000 25,000 25,000 25,000 Total $ 55,000 $ 55,000 $ 55,000 $ 55,000 $ 55,000 Pro Forma Income Statements ($000) 1 2 3 4 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%. Cantons 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 1.60. a. What is Cantons cost of equity capital? What is the after-tax cost of debt for the firm? b. 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 Cantons 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 Problems 349 market rate of interest on Cantons debt is equal to the 8% coupon, what is the current market value of the firms debt? What is the enterprise value of Canton? (Hint: Enterprise value can be estimated as the sum of the estimated values of the firms interest-bearing debt plus equity.) c. Using the market values of Cantons debt and equity calculated in Problem 9-5(b), calculate the firms after-tax weighted average cost of capital. Hint: kWACC = Cost of Debt a1 - Tax Rate b a Debt Value Enterprise Value b + Cost of Levered Equity a Equity Value Enterprise Value b d. What are the FCFs for Canton for years 1 through 4? e. 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 firms debt and equity? f. 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

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