Question

AFM Co. has a market value-based D/V ratio of 1/3. The expected return on the company’s unlevered equity is 20%, and the pretax cost of debt is 10%. Sales for the company are expected to remain stable indefinitely at $25 million. Costs amount to 60% of sales. The corporate tax rate is 30%, and the company distributes all its earnings as dividends at the end of each year. The company’s debt policy is to maintain a constant market value-based D/V ratio.

(a) If the company were all equity financed, how much would it be worth?

(b) What is the expected rate of return on the firm’s levered equity?

Answer 1

a. Since the expected return on unlevered equity is 20%, that will be its cost of capital. Total earnings of the company will be = 0.4 x 25 = $10 million. Hence, since no growth figure is given, we assume 0 growth. So, the value of the company will be = 10/0.2 = $50 million. (Value = Div/r).

b. Expected return on levered equity will be calculated by the method of calculating the cost of capital.

Cost of capital = WACC = Rd x D/V x (1-T) + Re x E/V.

20 = 10 x 1/3 x 0.7 + Re x 2/3.

Re = 26.5%.