The company is expected to generate $48 million in FCFF next year. The firm curr
ID: 2716434 • Letter: T
Question
The company is expected to generate $48 million in FCFF next year. The firm currently is extremely over-levered with a debt to capital ratio of 80%. The beta of the stock is now 2.72 and the pre-tax cost of debt is 12%. The marginal tax rate is 40%, the risk free rate is 4% and the market risk premium is 6%.You believe that new management can turn the firm around by restructuring the firm’s financing mix, to make it 50% debt and 50% equity. That will reduce the pre-tax cost of debt to 8%. Assuming growth rate of 3% in perpetuity, estimate the value of the firm if new management is able to restructure the debt in the firm.
Explanation / Answer
Cost of capital = Risk free rate + Beta x risk premium =4% + 2.72 x 6% =20.32% Debt Equity Total Current Capital Structure 0.8 0.2 Cost 12% 20.32% Weighted cost 9.60% 4.06% 13.66% Modified WACC: Debt Equity Total New Current Capital Structure 0.5 0.5 Cost 8% 20.32% Weighted cost 4.00% 10.16% 14.16% Value of the firm = Flee cashflows /(K-g) =48/(14.16%- 3%) =430.1075 million. Answer: 430.11 million