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Tweedledee Ltd and Tweedledum Ltd have identical expected operating cash flows of $600 million in perpetuity,...

Tweedledee Ltd and Tweedledum Ltd have identical expected operating cash flows of $600 million in perpetuity, but Tweedledee is financed entirely by equity, while Tweedledum’s capital structure includes 30 percent debt and 70 percent equity finance. Assume that the assumptions of a perfect capital market hold (including the assumption of risk-free debt), the measured equity beta for Tweedledee is 0.8, the yield on ten-year Government bonds is 6 percent and the market risk premium is 7 percent. Each firm has 500 million shares on issue.

What is the theoretical firm value for Tweedledum Ltd, rounded to the nearest $100 million?

Solutions

Expert Solution

Given,

Operating cash flow = $600 million in perpetuity

Weight of Debt = 0.3

Weight of Equity = 0.7

beta = 0.8

Risk free rate = Rf = 6%

Risk Premium = 7%

Let us calculate the Weighted average cost of capital(WACC) from above given details,

Formula to calculate WACC

Formula to calculate the value of the fiem given that cash flows are perpetual is,

Firm value = Operating cash flow / Weighted average cost of capital

we have Operating cash flow, let us calculate Weighted average cost of capital,

Formula to calculate WACC is,

WACC = (Wd*Rd) + (We*Re)

where,

Wd=weight of debt  

We = weight of equity

Rd= Cost of debt(Risk free rate in this case)

Re = Cost of Equity

Calculating Re,

Re= Risk free rate + (Beta*Risk Premium)

= Rf + B*Rpm

= 6% + (0.8*7%)

Re = 11.60%

WACC = (0.3*6%) + (0.7*11.6%)

WACC = 1.8% + 8.12%

WACC = 9.92%

Now, Let us put WACC in Firm value formula,

Firm Value = Operating cash Flow/ WACC

Firm Value = $600m/9.92%

Firm Value = $6048.38 million = $6000 million

jeff jeffy answered 3 years ago
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