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QUESTION

QUESTION # 1 :- You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating income of $350,000.

QUESTION # 1 :-

You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating income of $350,000. Income has grown 5% annually during the last five years, and it is expected to continue growing at that rate into the foreseeable future. The annual change in working capital is $30,000, and capital spending for maintenance exceeded depreciation in the prior year by $20,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. By introducing modern management methods, you believe the pretax operating income growth rate can be increased to 7% beyond the second year and sustained at that rate into the foreseeable future.

The ten-year Treasury bond rate is 6%, the equity risk premium is 6.5%, and the marginal federal, state, and local tax rate is 40%. The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 2.5 and 2.0, respectively. The business's target debt-to-equity ratio is 1, and its pretax cost of borrowing, based on its recent borrowing activities, is 8%. The business-specific risk premium for firms of this size is estimated to be 6.5%. The liquidity risk premium is believed to be 18%, relatively low for firms of this type due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain after the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to pay a 13% premium to reflect the value of control.

PLEASE ANSWER THE FOLLOWING FROM A TO G.

a. What is free cash flow to the firm in year 1?

b. What is free cash flow to the firm in year 2?

c. What is the firm's cost of equity?

d. What is the firm's after-tax cost of debt?

e. What is the firm's target debt-to-total capital ratio?

f. What is the weighted average cost of capital?

g. What is the business worth? 

           (Note: The first two terms represent the PV of the firm's operating cash flows before the application of modern management methods is fully implemented; the third term is the terminal value and reflects the anticipated sustained improvement in cash flows when the benefits of the new management techniques are fully realized.)

QUESTION # 2 :-

No Growth Incorporated had operating income before interest and taxes in 2011 of $250 million. The firm was expected to generate this level of operating income indefinitely. The firm had depreciation expense of $12 million that same year. Capital spending totaled $15 million during 2011. At the end of 2010 and 2011, working capital totaled $60 and $70 million, respectively. The firm's combined marginal state, local, and federal tax rate was 40% and its debt outstanding had a market value of $1.5 billion. The 10-year Treasury bond rate is 5.5% and the borrowing rate for companies exhibiting levels of creditworthiness similar to No Growth is 8%. The historical risk premium for stocks over the risk free rate of return is 5.2%. No Growth's beta was estimated to be 1.2. The firm had 2,500,000 common shares outstanding at the end of 2011. No Growth's target debt to total capital ratio is 35%.

A. Estimate free cash flow to the firm in 2011.

B. Estimate the firm's cost of capital.

C. Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2011, assuming that it will generate the value of free cash flow estimated in (a) indefinitely.

d. Estimate the value of the equity of the firm at the end of 2011. 

e. Estimate the value per share at the end of 2011.

PLEASE ANSWER THE FOLLOWING FROM A TO E

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