1. Lockheed Corporation
Lockheed Corporation (prior to its merger) reported EBITDA of $1290 million in 1993, prior to interest expenses of $215 million and depreciation charges of $400 million. Capital expenditures in 1993 amounted to $450 million, and working capital was 7% of revenues (which were $13,500). The firm had debt outstanding of $3.068 billion (book value), trading at a market value of $3.2 billion, and yielding a pre-tax interest rate of 8%. There were 62 million shares outstanding, trading at $64 per share, and the most recent beta is 1.10. The tax rate for the firm is 40%; the Treasury bond rate is 7% and the risk premium is 5.5%.
The firm expects revenue, earnings, capital expenditures and depreciation to grow at 9.5% per year from 1994 to 1998, after which the growth rate is expected to drop to 4%. (Capital spending will offset depreciation in the steady state period). The company also plans to lower its debt/equity ratio to 50% for the steady state (which will result in the pre-tax interest rate dropping to 7.5%).
Estimate the value of the firm (in year 1993).
2. Imperial Sandwich Plc
Imperial Sandwich Plc is to be established shortly. The founders are considering their options with regard to capital structure. A total of £5 m will be needed to establish the business and the two ways of raising these funds being considered here are:
a) Selling 1 million shares at £5.00
b) Selling 500,000 shares at £5.00 and borrowing £2.5 million with an interest rate of 10%.
The company plans to pay out the total net income as dividends to the shareholders. The possible outcome for the future EBIT is £750,000.
The corporate tax rate is 40%.
The founders has analyzed a proxy company and found it to have a beta of 1.2 and a market debt-equity ratio of 0.5. The risk-free rate is 5.8% and the market premium 4.5%
a) Calculate the WACC under each of the capital structures. Comment on the result.
b) Suppose that the founders of Imperial Sandwich Plc chose an equal debt-equity capital structure and established the company sometimes ago. The company generates a certain EBIT of 900,000 in perpetuity. But now the CFO of Imperial Sandwich has proposed that the company should sell equity and buy back debt in order to maximize its value. If 250,000 shares are issued at £ 5 each, £1.250 million is collected and used to retire £1.250 million of debt. Given your understanding of modern finance theory, discuss this proposal in term of its effects on firm value, price/earnings ratio and price per share. The corporate tax rate is 40% as above and the interest rate is 10% as above.