Question

M's FCF in the coming year is $8 million; this FCF is expected to grow at 3% per year later. M has an equity cost of capital of 13%, a debt cost of capital of 7% and it is in the 35% corporate tax bracket. If M keeps a 0.5 D/E ratio, what is its value and what us the value of teh internet tax shield?

Answer 1

Debt/equity ratio is 0.5

Thus for every 1 equity we have 0.5 debt

Thus, fraction of debt in total capital, = 0.5/(1+0.5) = 1/3

Fraction of equity =(1-1/3) = 2/3

The weighted average cost of capital, WACC = (%debt)*(cost of debt)(1-tax) + (%equity)*(cost of equity)

=(1/3)*(7)*(1-0.35)+(2/3)*(13)

= 10.1833%

The value of firm today is given by

FCF1/(WACC-growth rate)

Value = 8/(0.101833-0.03)

Value = $111.37 million

Interest tax shield is the reduction in income tax resulting from allowable deductions. Interest payments qualify for interest tax shield. The formula is given by

Interest expense*tax rate

As the value of interest expense is not given, we will assume a debt of $X

Thus, tax shield= $X*(0.35)*0.07