You have been recently hired as a financial analyst. When you arrive at work on Monday morning, the CFO of the firm sends you a message asking you to step into her office as soon as you have a free minute. Having been on the job just two weeks, you quickly decide you have a free minute and go to the executive floor, where the CFO has her office. You discover that the CFO wants you to educate her on the meaning and use of the APV valuation method. Although she does not elaborate on the reason for her request, you are aware of the office scuttlebutt that the board of directors is considering the prospect of taking the firm private and is in discussions with an investment banker about the particulars of the deal.
After leaving the CFO’s office, you decide that the best way to explain the use of the APV methodology is to construct a simple example. After thinking about it for an hour or so, you come up with the following illustration: Catch-Me Lures, Inc. is a very stable business with expected FCFs of $ 1,000 per year, which is likely to be constant for the foreseeable future. The firm currently has no debt outstanding and has an equity beta of 1.0. Given a market risk premium of 5% and a risk-free rate of interest of 8%, you estimate the unlevered cost of equity for the firm to be 8%.
a. If Catch-Me Lures’ expected FCF is a level perpetuity equal to $ 1,000 per year, what is your estimate of the enterprise value of the firm?
b. To illustrate the effect of debt financing on the value of Catch-Me Lures, you assume that the firm borrows $ 5,000 at a rate of 4% and that the firm pays taxes at a rate of 20%. Compute the amount of taxes the firm will “save” by virtue of the tax deductibility of its interest expense each year.
c. It is pretty obvious that borrowing a portion of the firm’s capital reduces its tax bill. But how much should you value the interest tax savings due to the use of debt financing? After thinking about it a bit, you decide to implement the basic notion of valuation and discount the future cash flows using a discount rate that reflects the risk of the cash flows. The cash flow estimation was easy. But what discount rate should you use?
d. What is the present value of the expected future tax savings from borrowing? What then is the value of the levered firm ( i. e., the APV valuation)?