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Gemco Jewelers earned $5 million in after tax operating income last year (EBIT*(1-T)). The firm had...

Gemco Jewelers earned $5 million in after tax operating income last year (EBIT*(1-T)). The firm had capital expenditures of $4 million and depreciation of $2 million during the year, and no NWC. Gemco has a pretax cost of debt of 3%, and a tax rate of 20%. The company has an unlevered beta of 1. The risk-free interest rate is 1.5% and the market risk premium is 4%.

1.Find Gemco’s Free Cash Flow (FCF)

2.Assume the FCF found is perpetual. If Gemco is all-equity financed, what is its value?

3. If Gemco has 5 million shares, what is the price per share?

4.If Gemco decides to issue $20 million dollars of perpetual debt and use the proceeds to repurchase shares, find the value of the tax savings (tax shield)

5.Find the value of Gemco after the debt issue.

6.What is the total value of Gemco's equity after the debt issue?

7.Find Gemco's price per share after the debt issue.

8.Find the cost of equity after the debt issue (in percent)

9.Find Gemco's WACC after the debt issue (in percent)

Solutions

Expert Solution

(1) EBIT(1-T) = $ 5 milllion, Capital Expenditure = $ 4 million, NWC = 0 and Depreciation = $ 2million
FCF = EBIT(1-T) + Depreciation - Capital Expenditure - NWC = 5 + 2 - 4 = $ 3 million

(2) Unlevered Beta = 1 = Bu, Risk-Free Rate = Rf = 1.5 % and Market Risk Premium = MRP = 4 %

Unlevered Cost of Equity = Ro = Rf + Bu x MRP = 1.5 + 1 x 4 = 5.5 %

Firm Value = FCF / Ro = 3 / 0.055 = $ 54.5455 million

(3) Number of Shares Outstanding = 5million

Price per Share = 54.5455 / 5 =$ 10.9091

(4) Target Debt Raised = D = $ 20 million. Tax Rate = t = 20 % and Pre-Tax Cost of Debt = r = 3 %

Value of Tax Shield = Total PV of Interest Tax Shield = (D x t x r) / r = (20 x 0.2 x 0.03) / 0.03 = $ 4 milion (discount rate equals the cost of debt as the debt is perpetual in nature)

NOTE: Please raise separate qeuries for solutions to the remaining sub-parts, as one query is restricted to the solution of only one complete question with a maximum of four sub-parts.

jeff jeffy answered 10 months ago
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