Caballos, Inc., has a debt to capital ratio of 27%, a beta of 1.3 and a pre-tax
ID: 2774358 • Letter: C
Question
Caballos, Inc., has a debt to capital ratio of 27%, a beta of 1.3 and a pre-tax cost of debt of 5.7%. The firm had earnings before interest and taxes of $ 630 million for the last fiscal year, after depreciation charges of $ 234 million. The firm had capital expenditures of $ 331 million, and non-cash working capital increased by $ 57 million. The firm also had a book value of capital of $ 1.8 billion at the beginning of the last fiscal year. (The treasury bond rate is 4.4 %, the market risk premium is 6.2 % and the firm has a tax rate of 40 %). Assume that the firm is in stable growth, and that the return on capital and reinvestment rates for the last fiscal year can be sustained forever. Estimate the Expected Growth Rate.
Explanation / Answer
Free Cash Flow to the firm = EBIT(1 - Tax Rate) + Depreciation - Changes in working capital - Capital Expenditure
= 630 (1 - 40%) + 234 - 57 - 331 =$224 million
Book Value of Capital at beginning of last year = $1.8 billion
Return on Capital = NOPAT/ Book value of capital = EBIT(1-Tax)/Book value of capital
= 630 (1 - 40%) / 1800 = 378/1800 = 21%
Reinvestment Rate = Net Investment/ NOPLAT
= (Investment in Capital Expenditure and Working Capital) / EBIT (1- Tax Rate)
= (331 + 57) / 630 (1 - 40%) = 388 / 378 = 102.65%
Assuming that the firm is in stable growth, and that the return on capital and reinvestment rates for the last fiscal year can be sustained forever,
Expected Growth Rate = Reinvestment Rate * Return on Capital = 102.65% * 21%
= 21.56%