Question

Lockheed martin corp LMT, a global security and aerospace company expects free cash flows of $183 million or $267 million each year with each outcome being equally likely. LMT’s corporate tax rate under the new US corporate tax rate 20%, and its unlevered cost of capital is 8%. The firm also has outstanding debt of $20 million and expects to maintain this level of debt permanently.

a) what is the value of LMT without leverage?

b) what is the calue of LMT with leverage?

Answer 1

(a) Possible Values of Free Cash Flow (FCF) are $ 183 million and $ 267 million with equal likelihood.

Expected Value of Perpetual FCF = 0.5 x 183 + 0.5 x 267 = $ 225 million

Unlevered Cost of Capital = 8 %, Fixed Debt = $ 20 million and Tax Rate = 20%

If the firm is considered to be unlevered, then the fixed debt and interest shield arising from the same are considered to be zero.

Hence, Value of Unlevered LMT = Expected FCF / Unlevered Cost of Capital = 225 / 0.08 = $ 2812.5 million

(b) If the firm is considered to be levered, then the firm value calculated in part(a) increase by the present value of firm's interest tax shield. This interest tax shield arises from the firm's constant perpetual debt of $ 20 million

Let the cost of debt (interest rate) be r %

Therefore, Interest Tax Shield (ITS) = Tax Rate x Cost of Debt x Debt = 0.2 x r x 20 = 4r $ million

Present Value of Interest Tax Shield = PV(ITS) = ITS / Cost of Debt = 4 x r / r = $ 4 million

Therefore, Levered Firm Value = 2812.5 + 4 = $ 2816.5 million