Question
An equity analyst is valuing a listed company that is expected to generate EBIT from year 1 onwards as given in Table 1. Table 1
An equity analyst is valuing a listed company that is expected to generate EBIT from year 1 onwards as given in Table 1.
Table 1
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
€16000 | €18200 | €16480 | €17100 | €17500 |
The EBIT margin is expected to be stable at 9.5% of sales from year 2 until year 5. The expected level of sales for year 1 is €160000. Additional assumptions are:
- Depreciation: 6% of sales, all years
- Recurrent Capex: 8% of sales for year 1, with percentage decreasing 35 basis points (0.35%) per year until year 4
- Change in working capital: 15% of yearly changes of EBIT
- Tax rate: 20%
- Target capital structure: debt/(debt + equity) ratio of 60%
- Asset beta: 1.4
- Risk-free rate: 2%
- Equity risk premium: 6%
- Debt spread: 4%
- Expected level of interest bearing debt at end of year 1: €30000
- Expected level of cash at the end of year 1: €12500
- Expected level of financial investments at the end of year 1: €15000
To answer the following questions make plausible assumptions if necessary. In case you prefer, standard characters can be used (e.g b rather than β, capital_sigma rather than ∑).
- Compute the Free Cash Flows to the Firm (FCF) for the period from year 1 until year 5, including year 5. Explain your answer. [10 marks]
It is often recognised that there exists an optimal capital structure (debt versus equity), that maximises the value of the company. Explain why, up until a certain level of debt, more debt increases the value of the company and, above that level, an increase in debt is expected to destroy value (everything else being constant). [10 marks]
- Given the target capital structure and the set of assumptions reported below Table 1, what is the discount rate to be used in this valuation exercise? Explain your answer. [10 marks]
- A validity condition to use the FCF model is the stability of capital structure. Do you agree? Explain your answer. [10 marks]
- The expected nominal growth rate of FCF in perpetuity is 1.25% and the current market capitalization of the company under analysis is €115000. What would be the equity analyst investment recommendation? Explain your answer.
Step by Step Solution
3.48 Rating (151 Votes )
There are 3 Steps involved in it
Step: 1
To compute the Free Cash Flows to the Firm FCF for the period from year 1 until year 5 we need to calculate the following components 1 EBIT Earnings B...Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started