Question

Firm ABC’s projected cash flows are as follows

Year	1	2	3	4 and 4+
CF	3,000	5,000	8,000	Grow at g = 1% forever

We can choose one of the following two capital structure plans:

	Debt	Equity
Plan A	20%	80%
Plan B	50%	50%
Plan C	70%	30%

The cost of debt are as follows

	Debt	Cost of debt
Plan A	20%	risk-free rate + 0.5%
Plan B	50%	risk-free rate + 1%
Plan C	70%	risk-free rate + 3%

The firm’s unlevered beta is 0.8, tax rate is 40%. Market return is 9%.

To calculate risk-free rate, we have the following information.

The 10-year Treasury bond with par value $100, annual coupon rate 3.125%, 10-year to maturity, is selling at $90.

What is the highest possible firm value?

	a	117,613.91
	b	121,494.40
	c	139,027.85
	d	129,035.03

Answer 1

Answer:

Correct answer is:

d	129,035.03

Explanation:

Calculation of risk free rate:

Treasury bond Par value = $100

Annual coupon = 100 * 3.125% = $3.125

Price = $90

Time to maturity = 10 years

Hence: Yield

= RATE (nper, pmt, pv,fv, type)

= RATE (10, 3.125, -90, 100, 0)

= 4.38%

Levered beta:

B_L = B_U * [1 + ((1 - Tax Rate) x Debt/Equity)]

Cost of equity = Risk free rate + Beta * (Market Return - Risk free rate)

Tax Rate = 40%

Calculation of Levered beta and cost of Equity:

Calculation of WACC:

Calculation of firm value at 3 different WACCs:

Out of 3 values highest value is $129,035.03

Hence option d is correct and other options are incorrect.