Question

Flagstaff Enterprises has an equity cost of capital of 13%, a debt cost of capital of 7%, and a corporate tax rate of 35%. At present, Flagstaff has a 0.80 debt-equity ratio and plans to maintain it (at 0.80) in the future. Flagstaff expects to have a free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter (forever).

a) Calculate the value of Flagstaff's interest tax shield.

Please show all work

Answer 1

The value is computed as shown below:

WACC is computed as follows:

= 1 / (1 + debt-equity ratio) x cost of equity + 0.80 / (1 + debt-equity ratio) x cost of debt

= 1 / (1 + 0.80) x 0.13 + 0.80 / (1 + 0.80) x 0.07

= 0.103333333

So, the value of unlevered firm will be as follows:

= Expected free cash flow / (WACC - growth rate)

= $ 8 million / (0.103333333 - 0.03)

= $ 109.0909091 million

WACC is computed as follows:

= 1 / (1 + debt-equity ratio) x cost of equity + 0.80 / (1 + debt-equity ratio) x cost of debt x (1 - tax rate)

= 1 / (1 + 0.80) x 0.13 + 0.80 / (1 + 0.80) x 0.07 x (1 - 0.35)

= 0.092444444

So, the value of levered firm will be as follows:

= Expected free cash flow / (WACC - growth rate)

= $ 8 million / (0.092444444 - 0.03)

= $ 128.113879 million

So, the value will be as follows:

= $ 128.113879 million - $ 109.0909091 million

= $ 19.02 million Approximately

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