Question

You have been asked by Med Parts Inc, a medical device maker, for advice on whether they are using the right mix of debt and equity to fund their operations. The firm has 120 million shares trading at $ 10 a share and $ 300 million in outstanding debt. The current levered beta for the firm is 1.10 and the pre-tax cost of borrowing is 6%. The marginal tax rate is 40%, the riskfree rate is 5% and the equity risk premium is 4%.

a) Estimate the current cost of capital for the firm.

b) If the market is valuing the firm correctly today (i.e., market value = fundamental value) and the expected free cash flow to the firm next year is $ 80 million, estimate the implied growth rate in this cash flow in perpetuity (given the cost of capital that you estimated in part a).

c) You estimate the optimal debt ratio for the firm to be 40% and believe that the cost of capital will drop to 8%, if you move to the optimal by borrowing money and buying back shares. If you buy back the shares at $10.25/share, estimate the increase in value per share for the remaining shares. [You will need part b to do part c. If you have trouble with part b, use 3% as your growth rate forever and specify that you did so]

Answer 1

a)

b)

the growth is as follows:

c)