Canton Corporation is a privately owned firm that engages in
Canton Corporation is a privately owned firm that engages in the production and sale of industrial chemicals, primarily in North America. The firm’s primary product line consists of organic solvents and intermediates for pharmaceutical, agricultural, and chemical products. Canton’s managers have recently been considering the possibility of taking the company public and have asked the firm’s investment banker to perform some preliminary analysis of the value of the firm’s equity.
To support its analysis, the investment banker has prepared pro forma financial statements for each of the next four years under the (simplifying) assumption that firm sales are flat (i. e., have a zero rate of growth), the corporate tax rate equals 30%, and capital expenditures are equal to the estimated depreciation expense.
In addition to the financial information on Canton, the investment banker has as-sembled the following information concerning current rates of return in the capital market:
The current market rate of interest on ten-year Treasury bonds is 7%, and the market risk premium is estimated to be 5%.
Canton’s debt currently carries a rate of 8%, and this is the rate the firm would have to pay for any future borrowing as well.
Using publicly traded firms as proxies, the estimated equity beta for Canton is 1.60.
a. What is Canton’s cost of equity capital? What is the after-tax cost of debt for the firm?
b. Calculate the equity free cash flows for Canton for each of the next four years. Assuming that equity free cash flows are a level perpetuity for year 5 and ­beyond, estimate the value of Canton’s equity. (Equity value is equal to the present value of the equity free cash flows discounted at the levered cost of equity.) If the of interest on Canton’s debt is equal to the 8% coupon, what is the cur-rent market value of the firm’s debt? What is the enterprise value of Canton? (Enterprise value can be estimated as the sum of the estimated values of the firm’s interest-bearing debt plus equity.)
c. Using the market values of Canton’s debt and equity calculated in Problem 9-5( b), calculate the firm’s after-tax weighted average cost of capital.
d. What are the FCFs for Canton for years 1 through 4?
e. Estimate the enterprise value of Canton using the traditional WACC model. Base your estimate on your previous answers, and assume that the FCFs after year 4 are a level perpetuity equal to the year 4 FCF. How does your estimate compare to your earlier estimate using the sum of the values of the firm’s debt and equity?
f. Based on your estimate of enterprise value, what is the value per share of equity for the firm if the firm has 2 million shares outstanding? Remember that your calculations up to this point have been in thousands of dollars.
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