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Unlevered and Levered Cash Flow

Based on an MBA project, a local environmental activist has asked you to evaluate the potential purchase of a company that manufacturers solar energy systems for homes, Solar Siding, Inc. Below, you have projections for the next three years of business, 2007, 2008, and 2009 for Solar Siding as a stand-alone business (if your client does not purchase it). Assume that you are standing one year prior to the 2007 cash flows, and that the marginal tax rate is 40%.

Year 2007 2008 2009
EBIT 2,000,000 2,200,000 2,500,000
Net income 900,000 1,020,000 1,200,000
Capital expenditures 600,000 800,000 500,000
Change in (noncash) net working capital 100,000 -100,000 0
Depreciation 400,000 400,000 500,000

a. What are the expected unlevered cash flow (UCF, also called free cash flow to the firm, or FCFF) and levered cash flow (LCF, also called free cash flow to equity) for 2007? For 2008? Assume no new net debt issues.

b. Assume that you expect cash flows for all years after 2009 to remain constant at the 2009 levels. Solar Siding has an asset beta of 1.2, the risk-free rate is 4%, and the market risk premium is 6%. Assume that the beta of Solar Siding's debt is zero (i.e., the pre-tax cost of debt is the risk-free rate), and that the amount of this debt is not expected to change over time. Also, assume that the EBIT and net income projections exclude interest income. What is Solar Siding's Enterprise Value (EV)?

c. Assume that your client believes that if it buys Solar Siding, the same projections will hold, except that pre-tax cash operating expenses are expected to decrease by $200,000 per year as a result of reductions in overhead expenses (largely because Solar Siding's CEO can be fired if the firm is acquired). Your client has an asset beta of 1 and is currently unlevered. What is the most they should be willing to pay for the equity of Solar Siding? Assume that the client (the acquirer) pays cash, and assumes Solar Siding's debt (i.e., it remains outstanding), and that Solar Siding has no significant excess cash on its balance sheet.

Solution Summary

The solution discusses unlevered and levered cash flow.

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