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sir in this question am unable to get the right MV of equity if i try using the geared Ke of 14% ! Am getting 37,664million as MV of equity. The examiner has used cost of capital method, but that should not matter. and the answer should still be the same. Can you show me the calculation from profit before interest and tax??? i got deprecation right. but after that…
Although the examiner has said that he would allow the MV to be calculated the way you have done, it does give the answer you have arrived at which is a lot different from his answer.
The reason is that because the interest is a fixed amount, the growth in the free cash flow to equity will be greater than 4% (as always results from higher gearing).
However the fact that the question does specifically say that the finance director wants to calculate the cost of capital does suggest that discounting the free cash flow at the WACC was the approach to take.
But again, because that had not been made completely clear in the question, you would have got full marks for that part of the answer even though it is a lot different 🙂
Hello Mr. John. I am trying to figure out why the PV in perpetuity was used in the MBO(Appendix 1 “Option 2”) and not in Appendix 3( For mining and shipping unit).
Because the question states that after the $1200 m investment in the “Mining business unit” this will result in its profits and cash flows growing by 4% per year in perpetuity.
Here they didn’t say that the cash flows of the “Machinery business unit” is growing in perpetuity. But in the answer they calculated the MBO value in perpetuity. I am a bit confused. Any explanation Sir? Thank you.
Sorry Mr. John. One rectification. I now understand that the perpetuity is used in Appendix 3.
However in calculating the estimated MBO value they divided by the rate of 10% which, I guess, is also in perpetuity. But the question doesn’t state that the Machinery business’s cash flows grow in perpetuity (but the Mining’s). So can you please explain why they used the perpetuity for the MBO value despite not mentioning that its cash flows is in perpetuity? Thanks and sorry for the confusion.The machinery business does not grow in perpetuity. The question says that it grows by 8% in the first year and then stays constant.
The discount factor for a constant perpetuity is 1/r which is why the answer divides the cash flow by 0.10.
One more question related to the same question above. Does it mean that this is the way to calculate the value whenever the cash flows grows only in the first year and then stays constant?
1/r is the discount factor for any constant perpetuity whether it grows in the first year or not.
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