Finance 435 Problem Set #3 Professor Sapp 1. Consider the following year-end projections for Krusty Krab Inc. Figures are in $ millions. 2019 2020 2021 2022 EBIT 100 120 150 190 Depreciation 30 35 40 45 Capital Expenditures 70 70 65 65 A Net Working Capital 15 15 -5 After 2022, EBIT is expected to grow at 3%, capital expenditures in excess of depreciation will grow at 3%, and net working capital will not change (ANWC = 0). Krusty Krab has a tax rate of 24%, its WACC is 9%, its net debt amounts to $650M, and the firm has 35M shares outstanding. a. Estimate the free cash flows for Krusty Krab for the five years 2019 to 2023. b. Based on the 2023 FCK, compute the terminal value as of year-end 2022. C- Compute the enterprise value of Krusty Krab as of year-end 2018. d Estimate the value per share of Krusty Krab equity. 2. Allthat Inc. is a privately owned business (i.e. it has no publicly traded stock). The owner/manager wishes to cash out and retire. He has decided that the firm is too small to justify going public and is instead seeking a private buyer. The owner was never comfortable with the use of significant amounts of debt. The firm has $4.2M in debt costing 8.58% and $1.8M in excess cash. The firm's free cash flow next year is projected to be $1.86M and is expected to grow at 4% forever. EBITDA for the last twelve months was $2.88M. You work for the legendary buyout firm Kohlberg Kravis Roberts (KKR), which is interested in acquiring Allthat. Based on similar firms (same size, industry, and modest debt relative to cash flows) that are publicly traded, you estimate that Allthat has a weighted average cost of capital of 11.5%. The tax rate is 26%. Your boss has asked you for the following analysis to acquire the firm in its current form (a) Estimate the current enterprise value and EV/EBITDA multiple of Allthat. b) What is the implied equity value of the current owner of the firm? (c) Firms in the same industry as Allthat and with similar debt have recently sold for an average enterprise multiple of 6.8 times EBITDA. What enterprise value does that imply for Allthat in a possible acquisition?" (d) Keeping in mind that KKR will only pay to acquire the equity stake (while inheriting the firm's debt obligations), how much would it actually cost KKR to buy Allthat based on the above estimate? (e) If the current owner agreed to this price in exchange for his equity claim, what is the estimated profit from the transaction for KKR? (f) What is the firm's ratio of debt to market value (D/(D+E))? (g) What is the implied cost of equity capital Re?' h) What is the unlevered cost of capital RA? Now your boss tells you he believes the firm could support a debt ratio of 70% which would provide substantial additional tax savings from the deductibility of interest payments. Due to the high leverage, he estimates that the average cost of debt Ro will increase to 10.3%, and the increased financial risk will, of course, raise the cost of equity- (i) Find the cost of equity under the new proposed capital structure. j) Find the new WACC. What is the overall impact of the increase in leverage on the cost of capital? (k) Use the new WACC to find the enterprise value of the highly levered firm. After removing the debt inherited from the previous owner and adding on the excess cash, how valuable would the firm be to KKR under this capital structure? (Note: Both the proceeds of the new debt issue and the resulting equity value accrue to KKR, so KKR captures all of this value regardless of how it is newly partitioned into debt and equity.) (1) If KKR paid the same price suggested above (in d) to acquire the equity of Allthat, what would be the profit to KKR under the new highly leveraged capital structure? By how much has expected profit increased by aggressively increasing the use of leverage? (m) If KKR gains this profit, who has "lost" this money from the increased use of leverage? (n) If KKR can create so much value by recapitalizing the firm, why didn't the firm's current owner already do this? (o) If Allthat were a publicly traded firm, would such low leverage make sense? Why