Question

Marpor Industries has no debt and expects to generate free cash flows of $ 16 million each year. Marpor believes that if it permanently increases its level of debt to $ 45 ​million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a​ result, Marpor's expected free cash flows with debt will be only $ 15 million per year. Suppose​ Marpor's tax rate is 40 %​,the​ risk-free rate is 5 % the expected return of the market is14 % and the beta of​ Marpor's free cash flows is 1.2 ​(with or without​ leverage).

a. Estimate​ Marpor's value without leverage.

b. Estimate​ Marpor's value with the new leverage.

Answer 1

Solution:

a)Calculation of Marpor's value without leverage

Required rate of return=Risk free rate+Beta(Market rate of return-Risk free rate)

=5%+1.2(14%-5%)=15.80%

Marpor's value=Free cash flow/Required rate of return

=$16 million/15.80%

=$101.27 million

Thus Marpor's value without leverage is $101.27 million

b)Calculation of Marpor's value with the new leverage

Required rate of return will be same as above i.e 15.80%

Marpor's value=(Free cash flow/Required rate of return)+(Value of debt*Tax rate)

=($15 million/15.80%)+($45 million*40%)

=$94.94 million+18 million

=$112.94 million

Thus Marpor's value with the new leverage is $112.94 million