Question

We want to determine the Value of a levered firm on January 1st, 2021. The company is expected to generate an EBIT of $400,000 on December 31st, 2021. The net working capital is not expected to increase and the depreciation expenses will equal capital expenditures. We also know that the company will distribute a dividend per share of $6 at the end of the year and that the growth rate of the earnings and dividends is 6%. The price per share of this company on January 1st, 2021 is $50. If the company has a debt to value ratio (D/V) equal to 20% and its cost of debt (rd) is 4%, what is the market value of the levered firm? Assume a corporate tax rate of 25%.

Answer 1

First, we calculate the cost of equity by using the Gordon Growth formula given as:
Price = Div/(R-g) = 50 = 6/(Re - 0.06)

Hence, Re = 18%.

We already know the cost of debt and the capital structure of the firm. So, now we calculate the WACC of the firmby the formula:

WACC = Rd x D/V x (1-T) + Re x E/V = 4 x 0.2 x 0.75 + 18 x 0.8 = 15%.

Since now that we have the WACC, we can calculate the market value using the free cash flows to the firm.

FCFF = EBIT x (1-T) + Depcreciation - Changes in Net working Capital - Capex

FCFF = 400,000 x 0.75 (all the other terms are cancelled)

FCFF = $300,000.

Since the growth rate is 6%, we again use the above formula to get the value of the firm:

Value of the levered firm = 300,000 x (1.06)/(0.15 - 0.06) = $3,533,333.33.

Note that we have multiplied the numerator here by (1+g) as we want the FCFF of the next year.