The corporate tax rate equals 10%. Mellow's free cash flow estimates are as follows: 2020, $1...

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• The corporate tax rate equals 10%. Mellow's free cash flow estimates are as follows: 2020, $1 billion; 2021, $1 billion; 2022, $1.2 billion; 2023, $1.3 billion; 2024, $1.4 billion. These cash flows reflect operational improvements the PE fund exports to make at Mellow once the buyout is complete. You may assume that the long-run free cash flow growth rate is 25. • You may assume that Mellow's 2020 cash flows will be received one year from now, and can hence be discounted for one period (ie. Po represents 2020 cash flows). Finally, a few notes on how to compute the finn's terminal value. You will first have to compute the firm's WACC at the end of 2024. Since you are computing WACC in 2024, the D/V and E/V ratios in your WACC formula should reflect the debt reduction that has taken place over the 2020-2024 period. You should be able to estimate the face value of debt D at the end of 2024 given the information above. However, you will not know the value of E, and hence, you will not know the value of V at the end of 2024. Now for the good news: you have seen a problem of this type before, and should know how to solve it! One final note. The calculations above assume that the cost of debt is constant. Since leverage ratios are changing, this is effectively a built-in violation of the Modigliani-Miller propositions. While this is not ideal, there is no single formula that exists to solve a re cursive valuation with time-varying discount rates, and such a formula (if it existed) would be very difficult to implement in a practical fashion. As such, we will bold our noses and assume that the cost of debt is constant, even though this is unlikely to be the case in reality. Please use recursive APV to determine the value of Mellow Minerals, Inc. 2 Terminal values [50 points] A 2012 paper published in the Journal of Portfolio Management argues that most profes sional analysts get their terminal values very wrong? In particular, standard models of terminal value such as the Gordon Growth Model (TV = FCF/(A − 9)) or multiples- based models do not explicitly restrict a firm's actual ROA to equal ra, the return required by investors. As a result, the author argues that firms can be earning a perpetual economic. profit or loss in many analyste models. Since very few firms could ever expect to earn a 2Crus, Bill (2012), "Raxmic Profitability and the Valuation of the Firm," Journal of Portfolio Man agement 29 (1), 122-135, 4 perpetual profit or loss (the former firm would eventually take over the world, while the latter would eventually go hankrupt), this implies that most of the terminal values used in practice may be incorrect. (Note: The article's author, Bill Cruise, is himself an equity analyst as well as a personal friend.) The author shows in the appendix to his paper that under some fairly basin assumptions, a firm's terminal value can be written as: TV - BV (ROA-9) TA 9 (1) where TV denotes terminal value, BV is the book value of the firm's debt and equity at the beginning of the terminal period, ROA is the (perpetual) return on assets, 9 is the (perpetual) free cash flow growth rate, and is the firm's discount rate. When ROA=TA (as would be the case if the firm is earning zero economic profits), the formula collapses to TV BV 1 BV. Thus, in the case where the firm is earning zero economic profits, the terminal value is simply equal to the book value of capital at the beginning of the terminal period. If ROA> T4, the firm is earning perpetual coonomic profits, while if ROA <TA the firm is earning perpetual economic losses. Let's now change topies for a second and talk about Tobin's q. Tobin's q can loosely be thought of as the present value of an additional $1 of capital (or, alternatively, as the market price per unit of capital). Empirically, Tobin's g is defined as the market value of capital divided by the book value of capital (that is, g = MV/BV in the terminology of equation (1)). In the context of stocks, this ratio is known as the price-to-book ratio. Note that since is defined per $1 of book capital, a firm's market value at any given point in time can be written as MVqBV (a) What is the precise link between the expression in parentheses in equation (1) and Tobin's q? Please state this link clearly. I am looking for a formula and the intuition behind that formula. [25 points] (b) What is the link between your answer to part (a) and the concept of not present value? Please explain. (25 pointe 5 • The corporate tax rate equals 10%. Mellow's free cash flow estimates are as follows: 2020, $1 billion; 2021, $1 billion; 2022, $1.2 billion; 2023, $1.3 billion; 2024, $1.4 billion. These cash flows reflect operational improvements the PE fund exports to make at Mellow once the buyout is complete. You may assume that the long-run free cash flow growth rate is 25. • You may assume that Mellow's 2020 cash flows will be received one year from now, and can hence be discounted for one period (ie. Po represents 2020 cash flows). Finally, a few notes on how to compute the finn's terminal value. You will first have to compute the firm's WACC at the end of 2024. Since you are computing WACC in 2024, the D/V and E/V ratios in your WACC formula should reflect the debt reduction that has taken place over the 2020-2024 period. You should be able to estimate the face value of debt D at the end of 2024 given the information above. However, you will not know the value of E, and hence, you will not know the value of V at the end of 2024. Now for the good news: you have seen a problem of this type before, and should know how to solve it! One final note. The calculations above assume that the cost of debt is constant. Since leverage ratios are changing, this is effectively a built-in violation of the Modigliani-Miller propositions. While this is not ideal, there is no single formula that exists to solve a re cursive valuation with time-varying discount rates, and such a formula (if it existed) would be very difficult to implement in a practical fashion. As such, we will bold our noses and assume that the cost of debt is constant, even though this is unlikely to be the case in reality. Please use recursive APV to determine the value of Mellow Minerals, Inc. 2 Terminal values [50 points] A 2012 paper published in the Journal of Portfolio Management argues that most profes sional analysts get their terminal values very wrong? In particular, standard models of terminal value such as the Gordon Growth Model (TV = FCF/(A − 9)) or multiples- based models do not explicitly restrict a firm's actual ROA to equal ra, the return required by investors. As a result, the author argues that firms can be earning a perpetual economic. profit or loss in many analyste models. Since very few firms could ever expect to earn a 2Crus, Bill (2012), "Raxmic Profitability and the Valuation of the Firm," Journal of Portfolio Man agement 29 (1), 122-135, 4 perpetual profit or loss (the former firm would eventually take over the world, while the latter would eventually go hankrupt), this implies that most of the terminal values used in practice may be incorrect. (Note: The article's author, Bill Cruise, is himself an equity analyst as well as a personal friend.) The author shows in the appendix to his paper that under some fairly basin assumptions, a firm's terminal value can be written as: TV - BV (ROA-9) TA 9 (1) where TV denotes terminal value, BV is the book value of the firm's debt and equity at the beginning of the terminal period, ROA is the (perpetual) return on assets, 9 is the (perpetual) free cash flow growth rate, and is the firm's discount rate. When ROA=TA (as would be the case if the firm is earning zero economic profits), the formula collapses to TV BV 1 BV. Thus, in the case where the firm is earning zero economic profits, the terminal value is simply equal to the book value of capital at the beginning of the terminal period. If ROA> T4, the firm is earning perpetual coonomic profits, while if ROA <TA the firm is earning perpetual economic losses. Let's now change topies for a second and talk about Tobin's q. Tobin's q can loosely be thought of as the present value of an additional $1 of capital (or, alternatively, as the market price per unit of capital). Empirically, Tobin's g is defined as the market value of capital divided by the book value of capital (that is, g = MV/BV in the terminology of equation (1)). In the context of stocks, this ratio is known as the price-to-book ratio. Note that since is defined per $1 of book capital, a firm's market value at any given point in time can be written as MVqBV (a) What is the precise link between the expression in parentheses in equation (1) and Tobin's q? Please state this link clearly. I am looking for a formula and the intuition behind that formula. [25 points] (b) What is the link between your answer to part (a) and the concept of not present value? Please explain. (25 pointe 5

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a The precise link between the expression in parentheses in equation 1 and Tobins q is as follows The expression in parentheses in equation 1 ie ROA r ... View the full answer