Question

Bluegrass Mint Company has a debt-equity ratio of .30. The required return on the company’s unlevered equity is 13.2 percent and the pretax cost of the firm’s debt is 7 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $20,100,000. Variable costs amount to 70 percent of sales. The tax rate is 25 percent and the company distributes all its earnings as dividends at the end of each year.

  

a.	If the company were financed entirely by equity, how much would it be worth? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)
b.	What is the required return on the firm’s levered equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-1.	Use the weighted average cost of capital method to calculate the value of the company. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)
c-2.	What is the value of the company’s equity? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)
c-3.	What is the value of the company’s debt? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)
d.	Use the flow to equity method to calculate the value of the company’s equity. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)

	a. Value of the company b. Required return % c-1. Value of the company c-2. Value of equity c-3. Value of debt d. Value of equity

     

Answer 1

Given Debt to equity ratio = 0.3

1 + D/E =V/E = 1.3

E/V = 1/1.3=77% =0.77

D/V = 0.23 = 23%

Cash flow in year 1 = Sales -VC - taxes = 20,100,000 - 0.7*20,100,000= 6,030,000*0.75 = $ 4,522,500

a)

Cost of Unlevered Equity, ke = 13.2 %

Value of the company = Cash flows/ ke = (4,522,500)/(13.2 %) = 34,261,363.64 = $ 34.26 Million

b)

Levered Cost of Equity = Unlevered cost *(1+D/E(1-t)) = 13.2%*(1+0.3* 0.75) = 16.17%

c-1 )

Value of the company = Cash flows/ WACC

WACC= ke * We + kd * Wd*(1-t) = ke* (E/V) + kd *(D/V)*(1-t) = 16.17%* 0.77 + 7%* 0.23*0.75 = 13.66%

Value of the company = (4,522,500)/13.66% = 33,107,613.47

C -2)

Value of debt = 0.23* 33,107,613.47 = 7,614,751.098

C- 3)

Value of Equity = 33,107,613.47 - 7,614,751.098 = $ 25,492,862.37

d)

Value of Equity = FCFE/ ke where FCFE = Free cash flow to equity

ke = ( FCFE/ Value of Equity )

FCFE = EBIT - Interest = 6,030,000 - 0.07*7,614,751.098 =6,030,000- 533032.57 = 5,496,967.43*0.75 = $ 4,122,725.57

ke = 4,122,725.57/25,492,862.37 = 16.17%