Exam 7: Merger and Acquisition Cash Flow Valuation Basics

For non-rated firms, the analyst may estimate the pretax cost of debt for an individual firm by comparing debt-to-equity or total capital ratios, interest coverage ratios, and operating margins with those of similar rated firms.

Free cash flow to equity is calculated using operating income.

The enterprise or free cash flow to the firm approach to valuation discounts the after-tax free cash flow available to the firm from operations at the weighted average cost of capital to obtain the enterprise value.

Which of the following is true of the enterprise valuation model?

The after-tax cost of borrowed funds to the firm is estimated by multiplying the pretax interest rate, i, by (1 - t), where t is the marginal tax rate for the firm.

Whether an analyst should use a short or long-term interest rate for the risk free rate in calculating the CAPM depends on when the investor receives their future cash flows.

Discounted cash flow and the asset-oriented valuation methods necessarily provide identical results.

The variable growth model would be most appropriate for valuing firms in the growth phase of their product life cycle.

The weights used to calculate the weighted average cost of capital for a firm with common equity and debt only represent the book value of equity and debt.

Betas do not vary over time and are quite insensitive to the time period and methodology employed in their estimation.

How would you estimate the equity value of a firm if you knew its enterprise value and the present value of all non-operating assets, non-operating liabilities, and long-term debt?

Abbreviated financial statements are given for Fletcher Corporation in the following table: 2010 2011 Revenues \ 600.0 \ 010 Operating expenses 520.0 600.0 Depreciation 16.0 18.0 Earnings before interest and taxes 64.0 72.0 Less Interest Expense 5.0 5.0 Less: Taxes 23.6 26.8 Equals: Net income 35.4 40.2 Addendum: Yearend working capital 150 200 Principal repayment 25.0 25.0 Capital expenditures 20 10 Yearend working capital in 2009 was $160 million and the firm's marginal tax rate is 40% in both 2010 and 2011. Estimate the following for 2010 and 2011: a. Free cash flow to equity. b. Free cash flow to the firm.

If free cash flow to the firm is expected to remain at $10 million indefinitely and the firm's cost of equity is .10, the present value of the firm is $100 million.

Financial Corporation wants to acquire Great Western Inc. Financial has estimated the enterprise value of Great Western at $104 million. The market value of Great Western's long-term debt is $15 million, and cash balances in excess of the firm's normal working capital requirements are $3 million. Financial estimates the present value of certain licenses that Great Western is not currently using to be $4 million. Great Western is the defendant in several outstanding lawsuits. Financial Corporation's legal department estimates the potential future cost of this litigation to be $3 million, with an estimated present value of $2.5 million. Great Western has 2 million common shares outstanding. What is the value of Great Western per common share?

Which one of the following factors is not considered in calculating the firm's cost of capital?

Ergo Unlimited's current year's free cash flow is $10 million. It is projected to grow at 20% per year for the next five years. It is expected to grow at a more modest 5% beyond the fifth year. The firm estimates that its cost of capital is 12% during the next five years and then will drop to 10% beyond the fifth year as the business matures. Estimate the firm's current market value.

No Growth Incorporated had operating income before interest and taxes in 2011 of $220 million. The firm was expected to generate this level of operating income indefinitely. The firm had depreciation expense of $10 million that same year. Capital spending totaled $20 million during 2011. At the end of 2010 and 2011, working capital totaled $70 and $80 million, respectively. The firm's combined marginal state, local, and federal tax rate was 40% and its debt outstanding had a market value of $1.2 billion. The 10-year Treasury bond rate is 5% and the borrowing rate for companies exhibiting levels of creditworthiness similar to No Growth is 7%. The historical risk premium for stocks over the risk free rate of return is 5.5%. No Growth's beta was estimated to be 1.0. The firm had 2,500,000 common shares outstanding at the end of 2011. No Growth's target debt to total capital ratio is 30%. a. Estimate free cash flow to the firm in 2011. b. Estimate the firm's cost of capital. c. Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2011, assuming that it will generate the value of free cash flow estimated in (a) indefinitely. d. Estimate the value of the equity of the firm at the end of 2011. e. Estimate the value per share at the end of 2011.

The calculation of free cash flow to equity includes all of the following except for

The effective tax rate is calculated from actual taxes paid based on accounting statements prepared for tax reporting purposes.

Free cash flow to the firm is often called enterprise cash flow.