Question

Use the information for the question(s) below. Flagstaff Enterprises is expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff 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 Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff as a levered firm is closest to: A. $111 million B. $100 million C. $114 million D. $140 million

Answer #1

Weight of Debt is calculated as

= 0.3333

Weight of Equity = 1-Weight of Debt

= 1-0.3333

= 0.6667

WACC = Cost of Equity*Weight of Equity + Cost of Debt* Weight of Debt*(1-Tax rate)

= 13*0.66667 + 7*0.33333*(1-0.35)

= 10.1833%

Value of Firm = FCF_{1}/(r-g)

Where, FCF_{1} is the expected free cash flow at time
1

r is the required return

g is growth rate

Value of Firm = $8million/(0.101833-0.03)

= $111.835 million

Since value of Flagstaff as a levered firm is closest to $111 million, the correct option is A.

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