Question

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

	A.	$152 million
	B.	$185 million
	C.	$140 million
	D.	$220 million

Answer 1

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