An entrepreneur that would like to create a new firm that specializes in electric cars. Your plan is to fund this new business by selling ownership in the business. That is, your firm will be all equity - you have no intention of issuing any debt.
In order to sell equity in this new business, you will need to calculate the fair value of this business, which involves determining the proper discount rate for electric car cash flows. Fortunately, there is one publicly traded electric car company (symbol: BOLT) you can use for comparison. However, this firm has a substantial amount of debt, which makes any comparison a little more complicated.
You run a regression of BOLT excess stock returns on excess market returns and obtain an equity beta of 2.5. Additional research informs you that the market capitalization (i.e. market value of equity) for BOLT is $600M, the value of debt is $400M (which was issued at par and will remain constant), and the beta of BOLT debt is 0.1. Assume a risk-free rate of 3 percent and a market risk premium of 6 percent.
a) What is the expected return on assets for BOLT?
Your business partner informs you that the expected return on assets you calculated in (a) is not quite the discount rate we should use for our electric car cash flows. The reason is that BOLT is a levered firm, and therefore the expected return on assets for BOLT includes both its electric car cash flows and tax shield cash flows. Specifically (note that OA stands for "operating assets" and TS"stands for "tax shield"):
ErA=( VOA * ErOA)/(VOA+VTS) + (VTS * ErTS)/ (VOA+VTS)
Because we are an all-equity firm, the proper discount rate to apply to our electric car cash flows would be the expected return on operating assets for BOLT. Assume a tax rate of 40 percent for the remainder of this problem.
b) What is the value of the tax shield for BOLT?
Assume that the expected return on BOLT tax shields is the same as the BOLT expected return on debt. Also keep in mind that the value of debt plus value of equity is equal to the value of operating assets plus value of tax shield (as both sums equal the value of the firm).
c) Calculate the expected return on operating assets using the expected return equation above.
d) Your firm expects to produce free cash flows of either $30M or $60M in perpetuity, with equal probability. How much money would you get if you sold 40 percent ownership in your firm?