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Question(s) / Instruction(s):

A friend of yours is trying to value the equity of a company and, knowing that you have read this book, has asked for your help. So far she has tried to use the FCFE approach. She estimated the cash flows to equity to be as follows:

Sales                                                      $800.0

-CGS                                                      -450.0

-Depreciation                                    -80.0

-Interest                                              -24.0

Earnings before taxes (EBT)        246.0

-Taxes (0.35 x EBT)                          -86.1

= Cash Flow to Equity                     $159.9

She also computed the cost of equity using CAPM as follows:

kE = kF + bE(Risk premium) = 0.06 + (1.25 x 0.084) = 0.165, or 16.5%

where the beta is estimated for a comparable publicly traded company. Using this cost of equity, she estimates the discount rate as

WACC = xDebtkDebt pretax(1 - t) + xcskcs

Based on this analysis, she concludes that the value of equity is $159.9 million/0.14 = $1,142 million.

Assuming that the numbers used in this analysis are all correct, what advice would you give your friend regarding her analysis?

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