FCF and Equity Value for a one year company?
I’ve been practicing DCFs quite a lot recently but a back to basics question has really stumped me.
Imagine a company with: Revenue $150 Costs $60 Depreciation $20 CapEx $20 No discount rate
It exists only for one year and will liquidate at the end of it, where it will be able to salvage its $10 of Net Working Capital. This NWC is already there and does not change during this one year. It has Debt of $50 with an interest rate of 10% and $20 cash.
So I calculate the unlevered Free Cash Flow with the normal formula ([Revenue-Costs-Depreciation-Interest]0.5)+Depreciation+Salvage-CapEx Which gives a FCF of $40, and I get a Tax shield of (0.150*0.5) $2.5 I get a total EV of $42.5, so subtracting the Net Debt of $30 I get equity value = $12.5
However I considered that the Equity holder wouldn’t actually be getting $12.5, because if you included the interest payment to get Net Income the FCFE (([Revenue-Costs-Depreciation-Interest]*0.5)+Depreciation+Salvage-CapEx) would be $7.5, so wouldn’t the equity holder actually only receive $7.5 at the end of the year?
This confuses me because I have always calculated unlevered FCF and used the WACC or APV to consider the financing when valuing, but in this one example I just can’t get over the concept that this would make an Equity Value larger than the Equity Holder would be getting back at the end of this one year?
Am I missing something conceptually here?
While you're back there in basics, revisit discount rate. This whole thing is just an exercise of utility if you don't understand that.
In the question is said to assume the discount rate is zero?
interest = .10 x 50 = 5; NI is 65; FCF is 42.5; add cash, subtract debt gets you 12.5 in equity value
you're doubling your interest
EDIT: sorry, it should've been that NI is 32.5 after tax
Ah okay that makes sense now I think. I guess I was just struggling with the concept of why we add interest expense back on.
Thank you for the help
trick questions, the assumption that WC levels will remain constant over the period (and no discount rate) indicates there is no risk associated with Cash-flows, thus no need for WC or operating cash. Thus, a rational investor would not maintain that cash balance with such a high cost of debt.
Tell your corp fin professor to suck it
Why are you including interest in UFCF?
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