Compute Korova’s FCF

Compute Korova’s FCF

Subject: Business    / Finance    

Question

Question 2: Valuation (34 marks)

The Korova Milk Bar is a stable drinking establishment with historical annual revenues of £100K and operating costs of £50K.

Korova claims annual depreciation of £30K and it annually replaces all depreciated property (capital expenditure).

Korova also has an outstanding interest only bond with face value £200K and a 5% interest rate. Korova does not retain any earnings, does not pay down the principal on its debt, and simply distributes any cash flow to shareholders once a year.

Based on past returns, Korova’s expected equity return is 10% per year. The corporate tax rate is 30% and as usual, depreciation and interest are tax deductable. All of the above cash flows are projected to stay the same for many years to come.

Hint: An interest only bond is a bond whose face value never needs to be repaid and the borrower simply pays interest payments every year.

(a) (5 marks) Compute Korova’s FCF

(b) (6 marks) Compute Korova’s cash flow to equity and cash flow to creditors (interest). Compare the total cash flow to stakeholders with the FCF and briefly comment on the difference.

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(c) (5 marks) Compute Korova’s market value of debt and equity as well as the firm’s total value.

(d) (5 marks) Compute Korova’s WACC

(e) (5 marks) State the relationship between your computations in (a), (d), and (c). Confirm that this indeed holds.

(f) (8 marks) Rick’s cafe? operates a few blocks from Korova, it is privately held and has no debt. Rick’s cafe? is about half the size of Korova and pulls in about half of Korova’s revenue but the overall business is very similar (ie its costs, depreciation, capital expenditures, etc are all about half of Korova’s). Estimate the value of Rick’s cafe?.

Hint: First use M&M’s 1st proposition to unlever Korova, then use the multiple’s approach.

Question 3: Trade-Off Theory (34 marks)

Assume that everyone is risk neutral with a discount rate of 0%. The tax rate is 20%. When someone defaults on debt the creditor must hire a lawyer to force liquidation; bankruptcy lawyers charge $2K for their services.

Kosmo is planning on transporting recycled cans from New York to Michigan where he can sell them for more money. This requires purchasing a truck for $5K. Unfortunately the truck is old and likely to break down soon, therefore it has no resale value. If Kosmo succeeds in making it to Michigan (60% probability) he will be able to sell the cans there for $10K. If he breaks down somewhere along the way (for example Indiana), he will only be able to sell the cans for $4K. Kosmo has no cash for the truck and must raise the cash somehow.

(a) (4 marks) Calculate this project’s pre-tax NPV.

(b) (9 marks) Elaine offers to lend Kosmo the $5K he needs under a standard debt agreement. Calculate the face value of the debt, the interest rate, and the present value of Kosmo’s payout. Assume all debt repayments (interest and principal) are tax deductable.

Hint: Do not forget about bankruptcy costs.

(c) (9 marks) Newman offers to give Kosmo the $5K in return for part of his future profits. Calculate what fraction of the profits must be promised to Newman and the present value of Kosmo’s payout. Does Kosmo prefer Elaine’s offer or Newman’s?

(d) (12 marks) Suggest a strategy that mixes debt and equity and makes Kosmo better off than (b) or (c). What is the face value of debt, the market value of debt and the interest rate? What amount must be raised from equity? What is the leverage? What is the present value of Kosmo’s payout?
Note: Assume that any strategy that results in equity’s payout being zero is equivalent to bankruptcy and the firm suffers bankruptcy costs.