Question

In: Finance

NewCap Corporation, a news media company, is re-examining its policy of financing all of its projects...

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

Solutions

Expert Solution

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

If you have any doubts please let me know in the comments.

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