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Chapter 10
Example 7
Eamon Co is forecast to generate a constant stream of post-tax cash flows
(after interest charges) of $10m per year.
The company is not listed, and no cost of equity has been calculated.
However, a similar listed entity, Frank Co, which operates in the same
business sector has a cost of equity of 10%.
Frank Co is all equity financed whereas Eamon Co has 20% debt and 80%
equity by market values. The tax rate is 30%, and the yield on Eamon's debt is
4%.
Required:
Calculate the value of Eamon Co, using the discounted cash flow
method.
Solution
The given post-tax and post-interest cash flows need to be discounted using
an appropriate cost of equity.
Although Frank Co operates in the same business sector, its gearing is
different. Hence, a risk adjusted cost of equity (suitable to Eamon Co's
circumstances) would be (using M & M's formula):
k eg = k eu + (k eu – k d) (1 – t) V D/V E
= 10% + (10% – 4%) (1 – 0.30) 20/80
= 11.05%
Therefore, the value of Eamon Co's equity is $10m/0.1105 = $90.5m
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