Grevillea Inc has no debt and expects to generate free cash flows of $18 million each year. Grevillea Inc believes that if it permanently increases its level of debt to $45 million, the risk of financial distress may cause it to receive less favourable terms from its suppliers. As a result, Grevillea Inc’s expected free cash flows with debt will be only $15 million per year. Suppose Grevillea Inc’s tax rate is 35%, the risk-free rate is 3%, the market risk premium is 7%, and the beta of Grevillea Inc’s free cash flows is 1.3 (with or without leverage). Grevillea Inc’s value after it has increased its level of debt is closest to
Grevillea Inc’s value with the new leverage
First we calculate the expected return using CAPM i.e.
r = risk free rate + beta * Risk premium
Risk free rate 3%
Risk Premium 7%
r = 5% + 1.3 × 7% = 12.10%
Value of Grevillea Inc, V = (FCF/r) + (debt*tax rate)
V = (15/0.1210) + (45*0.35)
V = $ 140 million
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