Question

Prokter and Gramble​ (PKGR) has historically maintained a​ debt-equity ratio of approximately 0.16. Its current stock price is $ 55 per​ share, with 2.8 billion shares outstanding. The firm enjoys very stable demand for its​ products, and consequently it has a low equity beta of 0.4 and can borrow at 4.7​%, just 20 basis points over the​ risk-free rate of 4.5​%. The expected return of the market is 9.8​%, and​ PKGR's tax rate is 25​%. 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 0.4​, it believes its borrowing costs will rise only slightly to 5.0​%. If PKGR announces that it will raise its​ debt-equity ratio to 0.4 through a leveraged​ recap, determine the increase or decrease in the stock price that would result from the anticipated tax savings. (two decimals)

Answer 1

Given, Market price= $55. Number of shares=2.8 Billion.

Hence equity capital= $154 Billion

Part (a ):

Market price= $55. Number of shares=2.8 Billion. Hence equity capital= $154 Billion

Given, beta= 0.4, Risk free rate (Rf)= 4.5% and market rate of return (Rm)= 9.8%

Therefore, as per CAPM, Cost of capital (Re)= Rf+Beta*(Rm-Rf)= 4.5%+0.4*(9.8%-4.5%) = 6.62%

Also given Free Cash Flow expected (FCF1)= $5.6 Billion

Constant growth rate (g)= 6.62%-(5.6/154) = 0.0662-0.036364= 0.029836 or, 2.9836%

Part (b):

Given, DE Ratio= 0.16, Equity =$154 Billion (as above)

Therefore, current debt= $154 Billion*0.16= $24.64 Billion

Proposed DER= 0.4. Hence proposed debt= $154 Billion*0.4 = $61.6 Billion

Increase in debt (D)= $61.6 Billion-= $24.64 Billion = $36.96 Billion

Also given, proposed cost of debt (Rd)= 5% and tax rate (T)= 25%

It is assumed that the increase in debt is for one year.

Therefore, increase in total share value due to anticipated tax saving= D*Rd*T/(1+Rd)

=$36.96 Billion*0.05*0.25/1.05= $ 0.44 Billion

Increase in per share value due to tax savings= 0.44 Billion/2.8 Billion= $0.16

(In case the increase in debt is perpetual, increase per share is D*T/# of shares

= 36.96*0.25/2.8= $3.3)