The company Youphone is expected to generate $48 million in FCFF next year. The
ID: 2743793 • Letter: T
Question
The company Youphone is expected to generate $48 million in FCFF next year. The firm currently is extremely over-levered with a debt to equity ratio of 4:1. 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%. The firm is expected to have a 2% perpetual growth rate.
What would the value of the firm be under the new financial structure?
a. 869.56
b. 769.23
c. 674.15
d. 645.16
e. None of the other answers.
Explanation / Answer
Levered beta = 2.72
Debt Equity ratio = 4:1
Let’s assume tax rate = 40%.
Unlevered beta is calculated below using following formula:
Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)
= 2.72 / [1+ (1 – 40%) × (4 / 1)]
= 2.72 / [1+ 2.4]
= 0.80
Hence, unlevered beta at tax rate of 40% is 0.80
Now management of company wants to restructure its capital structure and wants 50% debt and 50% equity.
So new levered beta with 50% debt and 50% equity is calculated below:
Beta (levered) = Unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]
= 0.80 × [1 + (1 - 40%) × (50% / 50%)]
= 0.80 × (1+ 0.6)
= 1.28
New levered beta with 50% debt and 50% equity is 1.28.
New Beta is 1.28.
Risk Free rate = 4%
Risk Premium = 6%
New cost of equity is calculated below using CAPM model:
Cost of equity = Risk free rate + Risk Premium × Beta
= 4% + 6% × 1.28
= 4% + 7.68
= 11.68%
New Cost Of equity is 11.68%.
Cost of debt = 12%
Tax rate = 40%
After tax cost of debt = 12% × (1 – 40%)
= 7.2%
Eight of equity = 50%
Weight of debt = 50%
WACC is calculated below:
WACC = 50% × 11.68% + 50% × 7.20%
= 5.84% + 3.6%
= 9.44%
New cost of capital is 9.44%
Expected FCFF = $48 million
Cost Of capital = 9.44%
Perpetuity growth rate = 2%
Value of firm = FCFF / (Cost of capital – Perpetuity growth rate)
= $48 / (9.44% - 2%)
= $48 / 7.44%
= $645.16 million
Current value of firm is $645.16 million
Hence, Option (D) is correct answer.