Question

The Chief Financial Officer (CFO) of the R60F Company is interested to identify the value of this company under multiple methods, for example, discounting dividend method using cost of equity or discounting cash flows using WACC. The company has 5 million shares, It has $60 million of debt at an interest rate of 6.4 per cent. The market believes that R60F can generate earnings of $14 million before interest and tax in perpetuity, and that R60F's beta coefficient is 2.1. R60F will pay out its available profits as dividends to its shareholders. Market risk premium is 5.6 per cent and govt bond yields 4.1 per cent. Tax rate is 40 per cent.

Requirement-a. Calculate cost equity and WACC for R60F.

Requirement-b. Calculate market value of R60F using suitable methods.

Requirement-c. Using your own words (would be checked for possibility of plagiarism), briefly comment on the consistency or inconsistency you find between discounting dividend and discounting cash flows to derive equivalent values.

Requirement-d. Using your own words (would be checked for possibility of plagiarism), briefly explain the impacts, if any, of business risk and financial risk of all-equity and leveraged firms on respective weighted average costs of capital.

Answer 1

ANSWER (a)

COST OF EQUITY= Rf+ b (eRm- Rf)

=4.1+ 2.1 (5.6)

=15.86 %

Where, Rf= Risk free interest rate, Rm= Risk premium, b= beta, here market risk premium given that is (Erm-Rf)

COST OF DEBT= I(1-t)

Where, I= Rate of interest, T= Tax rate

COST OF DEBT= 6.4(1-0.4)

= 3.84%

PARTICULARS	VALUE IN $
Earning before interest and tax	14000000
INTEREST	3840000
Earning before tax	10160000
TAX	4064000
Profit After Tax	6096000
SHARES	5000000
Earning Per share	1.2192

WHATEVER EARNED IS GIVEN AS DIVIDEND TO ALL SHAREHOLDERS, THUS PRICE OS SHARES = DIVIDEND/ COST OF EQUITY (Ke)

Po= D1/ Ke

HERE, D1= EPS, AS IN THIS CASE EPS=DPS, THUS,

Po= 1.21/ 15.86%

Po= 7.63 $

WACC
particulars	value IN $	weight	cost of capital	wacc
EQUITY	38146280	0.39	15.86	6.164268
DEBT	60000000	0.61	3.84	2.347516
TOTAL	98146280			8.511785
WACC	9.97%

ANSWER (b)

market value for shares will be= 7.63 $ (As per dividend discount model)

Po= D1/Ke

HERE, D1= EPS, AS IN THIS CASE EPS=DPS, THUS,

Po= 1.21/ 15.86%

Po= 7.63 $

ANSWER (c) If we apply dividend discount model, than there is chances of inconsistent market value while if we apply discounting cash flow to derive equivalent value, than we have present value of future cash flows so it is accurate to the extent the discounting rate is correct.