1
FINA 415
Winter 2025
Prof. Wajeeh Elali
Business Valuation
In-Class-Exercises (Q1)
Valuing a firm using FCFF Model
In the face of disappointing earnings results and increasingly assertive institutional
stockholders, EastWest Corp considered a major restructuring in 20X1. As part of this
restructuring, it considered the sale of its health division, which earned $560 million in
earnings before interest and taxes in 20X0, on revenue of $5.285 billion. The expected
growth in earnings was expected to moderate to 6% between 20X1 and 20X5 and to 4%
after that. Capital expenditures in the health division amounted to $420 million in 201X0
whereas depreciation was $350 million. Both are expected to grow 4% a year in the long
term. Working capital requirements are negligible.
The average beta of firms competing with EastWest’s health division is 1.15. Although
EastWest has a debt ratio [D/(D+E)] of 50%, the health division can sustain a debt ratio
[D/(D+E)] of only 20%, which is similar to the average debt ratio of firms competing in the
health sector. At this level of debt, the health division can expect to pay 7.5% on its debt,
before taxes. The tax rate is 40%, the market risk premium (MRP) is 5.5%, and the Treasury
bond rate is 7%.
Required:
1) Estimate the cost of capital for the division.
2) Estimate the value of the division.
3) Why might an acquirer pay more than this estimated value?
Answer:
a) The after tax cost of debt is 7.5% (1-.4)=4.5%, while the cost of equity = 7%
+1.15(.055) = 13.325%. Using a debt equity ratio of 20%, we find that the cost of
capital for the health division:
WACC= .20*4.5% + .80*13.325% = 11.56%.
2
b)
FCFF=EBIT(1-T) + Depreciation – Capital Expenditure Working Capital
EBIT EBIT(1-T) Depreciation Capital FCFF Terminal PV at 11.56%
($million) ($million) ($million) Expenditures ($million) Value(*) ($million)
($million) ($million)
t=0 560 336 350 420 266
20X0
20X1 593.6 356.16 364 436.8 283.36 253.9978487
20X2 629.216 377.5296 378.56 454.272 301.8176 242.5088265
20X3 666.969 400.1814 393.7024 472.44288 321.4409 231.5131229
20X4 706.9871 424.1923 409.4505 491.340595 342.3022 220.9915238
20X5 749.4063 449.6438 425.8285 510.994219 364.4781 5013.984319 3112.5448
t=n+1 779.3826 467.6295 442.8617 531.433988 379.0572
20X6
Value of 4061.5561
the
Division at
t=0
Note: you might use 6% growth rate instead of 4% for both Capital Expenditures and
Depreciation between 20X1-20X5.
(*)Terminal Value:
c) If the acquirer perceives some synergy between its existing business and the health
division, it might be willing to pay more. Also, if the health division is currently
mismanaged or if there are currently negative synergies, then an acquirer who
hopes to improve on this situation might be willing to pay more.
3
In-Class-Exercises (Q2)
Valuing a firm using FCFF Model
You have been asked to value CVS Corporation, a leading chain drugstores. You can apply
the following background information to value the CVS Corporation.
Base Year Information (20X1)
Earnings before interest and taxes in 20X1 =$532 million
Capital expenditures in 20X1 = $310 million
Depreciation in 20X1 =$207 million
Revenues in 20X1 =$7,230 million
Working capital as percent of revenues =25%
Tax rate = 36%
High-Growth Phase
Length of high-growth phase = 5 years
Expected growth rate in FCFF=8%
Beta =1.25
Cost of debt=9.50% (pre-tax)
Debt ratio=50%
Risk-free rate=7.5%
Market risk premium=5.5%
Stable-Growth Phase
Expected growth rate in FCFF=5%
Beta=1.0
Cost of debt=8.50% (pre-tax)
Debt ratio=25%
Capital expenditures are offset by depreciation
Risk-free rate=7.5%
Market risk premium=5.5%
Required:
1. Estimate the cost of capital (WACC) during the super growth period and
the stable period.
2. Estimate the total value of the firm.)
3. Estimate the value per share if there are 100 million shares outstanding,
and the firm has $1.2 billion in outstanding debt.
Answer:
4
20X1= Base Year
20X1 20X2 20X3 20X4 20X5 20X6 20X7
Revenue 7230 7808.4 8433.072 9107.718 9836.335 10623.24 11154.4041
EBIT 532 574.56 620.5248 670.1668 723.7801 781.6825 820.7667
EBIT(1-t) 340.48 367.7184 397.1359 428.9067 463.2193 500.2768 525.2907
Capital Expenditures 310 334.8 361.584 390.5107 421.7516 455.4917 0.0000
Depreciation 207 223.56 241.4448 260.7604 281.6212 304.1509 0.0000
Working Capital 1807.5 1952.1 2108.268 2276.929 2459.084 2655.81 2788.6010
Change in WC 144.6 156.168 168.6614 182.1544 196.7267 132.7905
FCFF (*) 111.8784 120.8287 130.495 140.9346 152.2093 392.5001
Terminal Value (**) 6423.898
PV(FCFF) 101.4954 99.44212 97.43037 95.45931 4040.823
Firm Value (***) 4434.65
g1 = Growth rate(high) 0.08
g2 = Growth
rate(stable) 0.05
WACC1 0.1023
WACC2 0.1111
Tax rate 0.36
Rf 0.075
Rdebt1 0.095
Rdebt2 0.085
Requity1 0.14375
Requity2 0.13
Beta1 1.25
Beta2 1
MRP 0.055
(D/V)1 0.5
(E/V)1 0.5
(D/V)2 0.25
(E/V)2 0.75
(*) FCFF = EBIT(1-t) + Depreciation - Cap Expenditures - Change in NWC
(**) TV=FCFF(n+1) / (COC - g)= FCFF(20X7) / COC2- g2) = 292.5001 / (.1111-.05)= 6423.897542
(***) Firm Value = Sum PV(FCFF)= 4434.65
WACC1= (.50)(.095)(1-.36)+(.50)(.14375)= 0.102275
WACC2= (.25)(.085)(1-.36)+(.75)(.13)= 0.1111
Requity1=Rf+beta(MRP)=(.075)+(1.25)(.055)= 0.14375
Requity2=Rf+beta(MRP)=(.075)+(1.00)(.055)= 0.13
Equity Value =
$3,234.65
PPS =$32.35
Business Valuation
Valuing a Firm Using FCFE
5
In-Class Exercises #3
You have been asked to value the shares of XYZ Corp. and have decided to use
a FCF to Equity valuation approach. You have been provided with data on
operating cash flows and capital expenditures below:
Year 1 Year 2 Year 3
Net Income $100 $140 $180
Depreciation 50 40 40
Addition to Working Capital 30 30 40
Capital Expenditures 40 50 60
After Year 3, FCFE is expected to grow at a constant rate of 6% forever. The
required rate of return on the stock is 12% and there are 150 shares outstanding.
Q1. What is your estimate for the FCFE in year 1, 2, and 3 based on this
information?
Q2. What is your estimate of the Terminal Value (TV) of XYZ Corp based on
this information?
Q3. What is your estimate of the entire firm’s value today based on this
information?
Q4. What is your estimate of the current share price of XYZ’s stock based on
this information?
Answer:
1) Let’s begin by computing FCFE for each year:
FCFE = NI + Dep – CapEx – Ch in WC
Y1=100+50-30-40=$80
Y2=140+40-30-50=$100
Y3=180+40-40-60=$120
Y4=120(1+.06) = $127.20
2) TV = 127.20 / (.12 - .06) = $2,120
3) Now we are ready to compute the total value of the firm’s equity:
Equity Value= 80(1.12)^-1+100(1.12)^-2+120(1.12)^-3+[(127.20)/(.12-.06)]^-3
Equity Value= 71.43+79.72+85.41+1,508.97=$1,745.53
4) Hence, the per share value is $1,745.53/150shares=$11.6369
