In: Finance
NewCap Corporation, a news media company, is re-examining its policy of financing all of its
projects entirely with equity. An analysis of its cost of capital suggests that the (after-tax) cost
of capital will be 1.50% lower than the current one if the firm moves to a 30% debt ratio (D/V).
The current beta of the firm is 0.90, the current Treasury bond (risk free) rate is 7% and the
market risk premium is 5.5%. The current earnings before interest and tax is $100 million, and
net capital expenditures (capex – depr) and net working capital spending are zero; the cash
flows are expected to grow at 5% forever. Assume that the expectation on future cash flows
will not be affected by any capital structure change. Tax rate is 40%. Do not consider other
factors that are not stated here.
(a) Estimate the value of the firm under the current debt ratio.
(b) Estimate the value of the firm under the optimal debt ratio
Beta = 0.90
Risk free rate(Rf) = 7%
Market risk premium (Rm -Rf) = 5.5%
Growth rate = 5%
Cost of equity can be calculated by using CAPM formula,
Cost of equity = Rf + Beta(Market risk premium)
Cost of equity(e) = 7% + 0.90(5.5%) = 11.95%
With no debt in capital structure, the cost of equity will be equal to the weighted avg cost of capital(WACC)
Hence e = WACC
FCFF = EBIT * (1 - Tax rate)
EBIT = $100 million
Tax rate = 40%
FCFF = 100 * (1 - 0.40)
= $60 million
a) Value of firm under current debt ratio =
= 60,000,000(1 + .05) / (.1195 - .05)
= $906,474,820.12 or $906.82 million
b) Under optimal debt structure, WACC is 1.5% lower than the current one.
Hence WACC = 11.95% - 1.5% = 10.45%
Value of firm under optimal debt ratio =
= 60,000,000(1 + .05) / (.1045 - .05)
= $1,155,963,302.75 or $1.155 billion
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