Valuation Problem Solution

You are analysing a company with the following attributes. The risk-free rate is 1.46% and market risk premium for the company is 6%. The company is traded on Straits Times (Singapore equity exchange index) and has a Beta of 0.97. The default spread for the firm is 0.94%. Assume effective corporate tax rate in Singapore to be 15%. Further, the cash flows for the company are mentioned below. Find cost of equity, cost of debt, WACC, current value of equity, and current value of the firm. Value of outstanding debt is 105.

Year    Cash Flow to Equity      Interest (long term)         Cash Flow to Firm   

1                   50                                   2.46                                          52.46

2                   60                                  2.46                                           62.46

3                   60                                  2.46                                           62.46

Terminal Value   710                                                                         814

This is an excellent example of the calculation of the cost of equity and the cost of debt. The solution uses a capital asset pricing model to price the cost of equity. This problem explains the default spread, market premium, and tax shield. Watch the video for the solution to the cost of debt and equity.

In the second part, we will calculate the Weighted Average Cost of Capital (WACC) using the cost of debt and cost of equity. Using WACC, calculate the present value of cash flows to the firm. The sum of these values gives the current value of the firm.

C_{e : Cost of Equity and} C_{d  Cost of Debt} 

WACC = C_e(E/E+D) + C_d(D/E+D)

Present Value of the Firm = Present value of Equity + Market Value of Debt

Present Value of Equity = Present Value of the Firm – Market Value of Debt