Pivot, Inc
Subject:FinancePrice:3.86 Bought27
Pivot, Inc. is currently valuing a new project that has the average risk of its investment projects. The project requires upfront R&D and marketing expenses of $10 million and a $30 million investment in equipment. The equipment will be obsolete in 3 years and will be depreciated using the straight-line method over that period. For each year over the next 3 years, the project offers annual sales of $100 million, has annual manufacturing costs of $30 million, and annual operating expenses of $10 million. Further, the project requires no net working capital in year 0, and $2.0 million in net working capital in each year from year 1 to year 2 and no net working capital in year 3. Beyond year 3, the project's free cash flows are expected to growth at an annual rate of 1% Pivot currently has 20 million outstanding shares with its stock price of $30 per share, $320 million in debt, $20 million in excess cash, the cost of debt of 5%, and the cost of equity of 10%, and the corporate tax rate of 40%. The firm plans to maintain a constant net debt-equity ratio for the foreseeable future, including any financing related to this new project. (i) Calculate the enterprise value of the project using free cash flows (WACC) method (ii) If the firm still maintains a constant net debt-to-equity ratio after taking this project, how much new debt must the firm borrow? By how much does the market value of the firm's equity increase?
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Net debt to equity ratio is constant in the question.
Net debt = debt reduced by excess cash in hand i.e. $320 million - $20 million = $300 million
Equity value is 20 million shares * share price of $30 / share = 20 * 30 = $600 million
Thus Net debt to Equity ratio is 1 : 2 (i.e. 300 / 600)
Total cost at the beginning of the year is $10 million + $30 million = $40 million
New Debt requried = $40 million * 1 / (2 + 1) = $13.33 million
Profit and loss statement is presented below
| Particulars | Year 1 | Year 2 | Year 3 |
| Sales | 100.00 | 100.00 | 100.00 |
| Expenses | 40.00 | 40.00 | 40.00 |
| Depreciation | 10.00 | 10.00 | 10.00 |
| Interest cost @5% | 0.67 | 0.67 | 0.67 |
| Profit before tax | 49.33 | 49.33 | 49.33 |
| Less tax @ 40% | 19.73 | 19.73 | 19.73 |
| Profit after tax | 29.60 | 29.60 | 29.60 |
Free cash flow to firm is calculated as below:
| Free cashflow to firm | Year 1 | Year 2 | Year 3 | Year 4 |
| Profit after tax | 29.60 | 29.60 | 29.60 | |
| Add depreciation | 10.00 | 10.00 | 10.00 | |
| Add Interest cost | 0.67 | 0.67 | 0.67 | |
| Less working capital used | 2.00 | 2.00 | - | |
| Free cashflow to firm | 38.27 | 38.27 | 40.27 | 40.67 |
weighted average cost of capital (WACC) = cost of equity * target weight of equity + cost of debt (after tax) * target weight of debt
= 10% * 2/3 + 5% * 0.60 * 1/3 = 7.67%
As the free cashflows from 4th year is expected to grow 1% indefinitely, the present value of cashflows at the end of 3rd year would be 40.67 / (0.0767 - 0.01) = $610 million
Enterprise value would be equivalent present value of free cashflow to firm (i.e. discounting free cashflows to firm by WACC)
= 38.27 / 1.0767 + 38.27 / (1.0767)^2 + (40.27 + 610 ) / (1.0767)^3
=35.54 + 33.01 + 521.04
= 589.60 million
Enterprise value is the sum of market value of debt + market value of equity
Thus market value of new equity = enterprise value - market value of debt
= 589.60 million - 13.33 million = $576.26 million
