Volante Corp (VC) is a local distributor of organic produce to local Boston area restaurants and stores. Management believes that revenues will grow at a high rate over the next 5 years. After that, free cash flow of the mature business will grow at the same 5% long term rate as the industry as a whole. Exhibit 1 contains projections for the expected revenues and cash flows achievable of the firm. VC's financial advisor is debating how to assess the firm's debt capacity and the impact of any financing decisions on value. In thinking about how much debt to utilize, two options are being considered. The first is to maintain a fixed dollar amount of debt, which would be kept in perpetuity. The second alternative is to adjust the amount of debt so as to maintain a constant ratio of debt to firm value. Exhibit 2 contains information on market conditions as well as assumptions regarding the firm's expected cost of debt. Please answer the following questions. Your answers should contain sufficient notation to explain your calculations. 1. What is the value of the company assuming the firm is entirely equity financed? What are the annual projected free cash flows? What discount rate is appropriate? 2. Value the company using the Adjusted Present Value (APV) approach assuming the firm raises $750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity. 3. Value the company using the Weighted Average Cost of Capital (WACC) approach assuming the firm maintains a constant 25% debt-to-market value ratio in perpetuity. 4. What are the end-of-year debt balances implied by the 25% target debt-to-value ratio? (hint: each year, the debt outstanding will equal 25% of the value you calculate for the value as of that year, i.e. the PV of FCFs beyond that year) 5. Using the debt balances from question 4, use the Capital Cash Flow (CCF) approach to value the company. 6. How do the values from the APV, WACC, and CCF approaches differ? Why or why not? Exhibit 1 Financial projections (in thousands of dollars). Year ending: Year 1 Year 3 Year 4 Year 5 Year 2 2,400 Sales 1,200 3,900 5,600 7,500 EBITD 180 840 Depreciation EBIT Tax Expense EBIAT (200) (20) 8 (12) 360 (225) 135 (54) 81 585 (250) 335 (134) 201 (275) 565 (226) 339 1,125 (300) 825 (330) 495 300 300 300 300 300 CAPEX Investment in Working Capital 0 0 0 0 0 "EBITD is the Earnings Before Interest, Taxes and Depreciation. EBIAT is the Earnings Before Interest and After Taxes. Taxes are calculated assuming no interest expense. Assume today is fiscal year end 0 Exhibit 2 Additional Assumptions 5.0% 6.8% Risk-free Rate (Rt) Cost of Debt (R) Market Risk Premium Marginal Corporate Tax Rate Debt Beta (Ba) 7.2% 40% 0.25 Asset Beta 1.50 Exhibit 3 ($MM) Sales EBIT Depreciation and amortization Changes in working capital Capital expenditures Risk-free rate Risk premium Terminal value growth rate Shares outstanding Tax rate Year 1 3,271.2 171.4 83.5 (32.7) (159.2) .03 .05 3% 75 million 35% Year 2 3,387.9 191.9 95.3 (37.3) (141.2) Year 3 3,537.4 210.3 96.2 (17.7) (90.7) Year 4 3,777.5 235.9 103.0 (41.6) (100.0) Year 5 3,966.4 238.0 112.0 (39.7) (120.0) Volante Corp (VC) is a local distributor of organic produce to local Boston area restaurants and stores. Management believes that revenues will grow at a high rate over the next 5 years. After that, free cash flow of the mature business will grow at the same 5% long term rate as the industry as a whole. Exhibit 1 contains projections for the expected revenues and cash flows achievable of the firm. VC's financial advisor is debating how to assess the firm's debt capacity and the impact of any financing decisions on value. In thinking about how much debt to utilize, two options are being considered. The first is to maintain a fixed dollar amount of debt, which would be kept in perpetuity. The second alternative is to adjust the amount of debt so as to maintain a constant ratio of debt to firm value. Exhibit 2 contains information on market conditions as well as assumptions regarding the firm's expected cost of debt. Please answer the following questions. Your answers should contain sufficient notation to explain your calculations. 1. What is the value of the company assuming the firm is entirely equity financed? What are the annual projected free cash flows? What discount rate is appropriate? 2. Value the company using the Adjusted Present Value (APV) approach assuming the firm raises $750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity. 3. Value the company using the Weighted Average Cost of Capital (WACC) approach assuming the firm maintains a constant 25% debt-to-market value ratio in perpetuity. 4. What are the end-of-year debt balances implied by the 25% target debt-to-value ratio? (hint: each year, the debt outstanding will equal 25% of the value you calculate for the value as of that year, i.e. the PV of FCFs beyond that year) 5. Using the debt balances from question 4, use the Capital Cash Flow (CCF) approach to value the company. 6. How do the values from the APV, WACC, and CCF approaches differ? Why or why not? Exhibit 1 Financial projections (in thousands of dollars). Year ending: Year 1 Year 3 Year 4 Year 5 Year 2 2,400 Sales 1,200 3,900 5,600 7,500 EBITD 180 840 Depreciation EBIT Tax Expense EBIAT (200) (20) 8 (12) 360 (225) 135 (54) 81 585 (250) 335 (134) 201 (275) 565 (226) 339 1,125 (300) 825 (330) 495 300 300 300 300 300 CAPEX Investment in Working Capital 0 0 0 0 0 "EBITD is the Earnings Before Interest, Taxes and Depreciation. EBIAT is the Earnings Before Interest and After Taxes. Taxes are calculated assuming no interest expense. Assume today is fiscal year end 0 Exhibit 2 Additional Assumptions 5.0% 6.8% Risk-free Rate (Rt) Cost of Debt (R) Market Risk Premium Marginal Corporate Tax Rate Debt Beta (Ba) 7.2% 40% 0.25 Asset Beta 1.50 Exhibit 3 ($MM) Sales EBIT Depreciation and amortization Changes in working capital Capital expenditures Risk-free rate Risk premium Terminal value growth rate Shares outstanding Tax rate Year 1 3,271.2 171.4 83.5 (32.7) (159.2) .03 .05 3% 75 million 35% Year 2 3,387.9 191.9 95.3 (37.3) (141.2) Year 3 3,537.4 210.3 96.2 (17.7) (90.7) Year 4 3,777.5 235.9 103.0 (41.6) (100.0) Year 5 3,966.4 238.0 112.0 (39.7) (120.0)