Question

A firm is expected to grow in perpetuity at a rate of 5%. If the next year free cashflow expected is 20 million, the cost of equity is 15%, cost of debt is 8% and the target debt to equity ratio is 1, then what is the value of this firm today if the tax rate is 20%?

Answer 1

Given about a firm,

It is expected to grow at g = 5% in perpetuity.

Expected Free cash flow FCF1 = $20 million

Cost of equity Ke = 15%

Cost of Debt Kd = 8%

D/E ratio = 1

=> Weight of debt Wd = 50%

Weight of equity We = 50%

Tax rate T = 20%

First calculating Cost of capital, Kc

Kc = Wd*Kd*(1-T) + We*Ke = 0.5*8*(1-0.2) + 0.5*15 = 10.70%

So, Value of firm is calculated using constant growth model,

Value of Firm = FCF1/(Kc-g) = 20/(0.107-0.05) = $350.88 million