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.
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
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