Question 11.4: Leo Ltd has just been formed and has been financed by a £20 ...
Leo Ltd has just been formed and has been financed by a £20 million issue of share capital and a £10 million issue of loan notes. The proceeds of the issue have been invested in non-current assets with a life of three years and during this period these assets will depreciate by £10 million per year. The operating profit after tax is expected to be £15 million each year. There will be no replacement of non-current assets during the three-year period and no investment in working capital. At the end of the three years, the business will be wound up and the non-current assets will have no residual value.
The required rate of return by investors is 10 per cent.
The SVA approach to determining shareholder value will be as follows:
| Year | FCF | Discount rate | Present value |
| £m | 10% | £m | |
| 1 | 25.0* | 0.91 | 22.8 |
| 2 | 25.0 | 0.83 | 20.7 |
| 3 | 25.0 | 0.75 | \underline{18.7} |
| Total business value | 62.2 | ||
| Less Loan notes | \underline{(10.0)} | ||
| Shareholder value | \underline{52.2} |
* The free cash flows will be the operating profit after tax plus the depreciation charge (that is, £15m £10m). In this case, there are no replacement non-current assets against which the depreciation charge can be netted off. It must therefore be added back.
The EVA^\circledR approach to determining shareholder value will be as follows:
| Year | Opening capital invested (C) |
Capital charge (10% × C) |
Operating profit after tax |
EVA^\circledR | Discount rate 10% |
Present value of EVA^\circledR |
| £m | £m | £m | £m | £m | ||
| 1 | 30.0* | 3.0 | 15.0 | 12.0 | 0.91 | 10.9 |
| 2 | 20.0 | 2.0 | 15.0 | 13.0 | 0.83 | 10.8 |
| 3 | 10.0 | 1.0 | 15.0 | 14.0 | 0.75 | \underline{10.5} |
| 32.2 | ||||||
| Opening capital | \underline{30.0} | |||||
| 62.2 | ||||||
| Less Loan notes | \underline{(10.0)} | |||||
| Shareholder value | \underline{52.2} | |||||
* The capital invested decreases each year by the depreciation charge (that is, £10 million).