Question

You have been asked by the owner of Tectonics Software, a small firm that produces and sells computer software, to come up with an estimate of value for the firm for an initial public offering. 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 pretax interest expenses amounted to $1 million. The book value of equity is $10 million. The average unlevered beta of publicly traded software firms is 1.20, and the average market value of equity of these firms is, on average, three times the book value of equity.

Answer 1

To estimate the value of Tectonics Software for an initial public offering (IPO), we can use the market value of equity of publicly traded software firms as a benchmark. We calculate the levered beta and cost of equity to estimate the total value of the firm.

Step-by-step explanation:

To estimate the value of Tectonics Software for an initial public offering (IPO), we can use the market value of equity of publicly traded software firms as a benchmark. According to the information provided, the average market value of equity for these firms is three times the book value of equity. Since the book value of equity for Tectonics Software is $10 million, we can estimate the market value of equity as $10 million multiplied by three, which equals $30 million.

Next, we need to consider the effect of leverage on the value of the firm. The firm has debt outstanding of $10 million, on which pretax interest expenses amounted to $1 million. This means the firm has a pretax cost of debt of $1 million. To account for the effect of leverage, we calculate the levered beta using the unlevered beta and the capital structure of the firm.

Lastly, we can use the Capital Asset Pricing Model (CAPM) to estimate the cost of equity for Tectonics Software. The CAPM formula is: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. By using this formula and the levered beta, we can calculate the cost of equity for Tectonics Software. Once we have the cost of equity and the market value of equity, we can estimate the total value of the firm for the IPO.