Case Study - Valuing a Private Firm

You have been asked by the owner of a small firm that produces and sells computer software to estimate the value of his firm. The firm had revenues of $20 million in the most recent year, on which it made earnings before interest and taxes of $2 million. The firm had debt outstanding of $10 million, on which pre-tax interest expenses amounted to $1 million. The book value of equity is $10 million. The average beta of publicly traded firms that are in the same business is 1.30, and the average debt-equity ratio is 0.2 (based upon the market value of equity). The market value of equity of these firms is, on average, three times the book value of equity. All firms face a 40% tax rate. Capital expenditures amounted to $1 million in the most recent year, and were twice the depreciation charge in that year. Both items are expected to grow at the same rate as revenues for the next five years, and to offset each other in steady state. 

The revenues of this firm are expected to grow 20% a year for the next five years, and 5% after that. Net income is expected to increase 25% a year for the next five years, and 8% after that. The Treasury bond rate is 7% for this case study which does not represent the current interest rate environment. 

A. Estimate the cost of equity for this private firm. 

B. Estimate the cost of capital for this private firm. 

C. Estimate the value of the owner's stake in this private firm, using both the firm approach and the equity approach.