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You are thinking of starting the following business. It requires an investment in equipment today of 5 million that can be depreciated straight line over
You are thinking of starting the following business. It requires an investment in equipment today of 5 million that can be depreciated straight line over 5 years. You expect sales for the first year to be 4 million with a cost of goods sold of 2 million. In the second year you expect your sales and cost of goods sold to grow by 20%. The level of working capital required to operate is 20% of sales. The corporate tax rate is 25%. All cash-flows occur at the end of the year, except the investments in equipment and working capital that must take place at the beginning of the year. The beta of the equity of the firm is 1. The risk-free rate is 4% and the market risk premium is 5%. You plan to finance the business with debt and equity, with a debt-to-equity ratio of 1/4. The cost of the debt is 5%. a) (10 points) Please compute the free-cash flows of this business today and in each of the next two years. b) (5 points) Please calculate the cost capital for this business. c) (10 points) Assuming that after year 2 the firms free cash-flows are expected to grow at the rate of 5% per year in perpetuity, what is the value of this business? Please comment on the assumption made for the perpetual growth rate of free cash-flows (maximum 5 lines)
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