Question

An equity-only firm is valued at $500 million and has a beta of 1.1.

One of its suppliers has asked the firm for a 1-year loan. The supplier wants to borrow $60 millon and pay back $62.1 million next year.

The risk-free rate is 3% and the equity premium is 4%.

Part 1
Without the loan and assuming constant cash flows, what is the expected cash flow per year?

0+ decimals

Part 2
What is the value of the firm with the loan (in $ million)?

0+ decimals

Part 3
What is the new cost of capital after extending the loan?

Answer 1

Part a)
The value of the firm is given as $500 million.
The cost of capital for the firm is 7%

Cost of Capital = Risk-Free Rate + (Beta *Equity Premium)

3% + (1.1 *4%) = 7.4%

Free Cash Flow / (1+Cost of Capital) ^ Duration = Value of the Firm

If the cash flow is constant for perpetual period then
FCF * (1 + Growth Rate) / (WACC -Growth Rate)

FCF / WACC

FCF / (0.074) = 500

FCF = 37 million

Part b)
The loan is an asset and it indicates financing activity cash flow.
The net gain from the loan extended is $2.1 million in the year.
We will have to calculate the PV of that gain.

PV = PMT / (1+Interest Rate) ^ Duration

500 + (2.1 / (1.0740)
= 500 + 1.9553
= 501.9553 million

Part C

Free Cash Flow / WACC = Value of the Firm

37 / x = 501.9553

x = 37 / 501.9553
X = 0.0737 or 7.37%