Question

Prokter and Gramble​ (PKGR) has historically maintained a​ debt-equity ratio of approximately 0.23. Its current stock price is $53 per​ share, with 2.9 billion shares outstanding. The firm enjoys very stable demand for its​ products, and consequently it has a low equity beta of 0.575 and can borrow at 3.7% just 20 basis points over the​ risk-free rate of 3.5%.The expected return of the market is10.1%, and​ PKGR's tax rate is 35%

a. This​ year, PKGR is expected to have free cash flows of ​$5.6 billion. What constant expected growth rate of free cash flow is consistent with its current stock​ price?

b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher​ debt-equity ratio of 0.575 it believes its borrowing costs will rise only slightly to 4.0%.If PKGR announces that it will raise its​ debt-equity ratio to0.575 through a leveraged​ recap, determine the increase or decrease in the stock price that would result from the anticipated tax savings.

Answer 1

Answer to part (a):
Debt-Equity Ratio	0.23
Equity Beta	0.575
Levered Beta	= Equity Beta (1+ Debt-Eaquity Ratio)
Levered Beta	= 0.575 (1 + 0.23/1.23)
Levered Beta	= 0.575 (1.18699)
Levered Beta (B)	= 0.6825
Risk-Free Rate (Rf)	3.50%
Market Return (Rm)	10.10%
Required Return (Re)	= Rf + (Rm-Rf)B
	= 3.5% + (10.10 - 3.5)0.6825
Required Return (Re)	= 8%
Debt Rate (r)	3.70%
Tax Rate (t)	35%
Stock Price (P)	$                                               53.00
Shares O/s	2.9 Billion
Value of Equity (Ve)	= Share Price * Shares O/s
	= 53 * 2.9 B
Value of Equity (Ve)	= $ 153.70 Billion
Free-cash flows	$ 5.6 Billion
Value of Equity (Ve)	= FCFF / Ke-g
153.7	= 5.60 / 8% - g
Growth (g)	= 4.36%
Answer to part (b):
Debt Rate (r)	4.00%
Tax Rate (t)	35%
Levered Beta	= Equity Beta (1+ Debt-Eaquity Ratio)
Levered Beta	= 0.575 (1 + 0.575/1.575)
Levered Beta (B)	= 0.785
Required Return (Re)	= Rf + (Rm-Rf)B
	= 3.5% + (10.10 - 3.5)0.785
Required Return on equity (Re)	= 8.68%
Value of Equity (Ve)	= FCFF / Ke-g
	= 5.60 / 8.68 - 4.36
Value of Equity (Ve)	= $ 129.63 Billion
Stock Price	= 129.63 / 2.9
	= $ 44.70/-
Stock Price will decrease