Question

Monaca Ltd has no debt and is currently valued at $800 million.

The Company is considering a permanent increase in debt of $90 million.

Suppose the tax rate is 30%, the weighted average cost of capital is 15% and the cost of debt is 6%.

Required:

1. Estimate the company’s value with the new leverage. Express your answer to the nearest million.
2. Monaca Ltd believes that if it permanently increases its level of debt, the risk of financial distress may cause it to lose some customers and receive less favourable terms from its supplier. As a result, the company’s expected free cash flows with debt will be decreased by $6 million each year forever. Estimate the company’s value with the new leverage, incorporating the effects of financial distress. Express your answer to the nearest million.

Answer 1

a. Assuming no change in company's cash flows, the effect of substituting equity with debt would not change the Enterprise Value (EV) of the company. Also, it is assumed that future cash flows are rightly discounted by weighted average cost of capital rather than cost of equity to arrive at the value of $800 million.

Given EV = Equity Value + Net Debt, in the case of no debt, EV = 800 + 0 = $800 million

Now with debt, 800 = New Equity Value + 90. Hence, New Equity Value = 800 - 90 = $710 million

b. With change in future cash flows, we now need to find the impact of reduced cash flow every year discounted by the weighted cost of capital. We would use the formula for dicounting $6mn till perpetuity, which is

= (6 * (1/(1+15%)) / (1 - (1/(1+15%))) = $40 million

Hence, new Equity Value factoring the impact of reduction would be = 710 - 40 = $670 million