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Question 1:
HiFlyer Corporation does not currently have any debt. Its tax rate is 0.4 and its unlevered beta is estimated by examining comparable companies to be 2.0. The 10-year Treasury bond rate is 6.25% and the historical risk premium over the risk free rate is 5.5%.
a. Calculate the firm’s current cost of equity.
b. Estimate the firm’s cost of equity after it increases its leverage to 75% of equity?
Question 2:
ABC Incorporated shares are currently trading for $32 per share. The firm has 1.13 billion shares outstanding. In addition, the market value of the firm’s outstanding debt is $2 billion. The 10-year Treasury bond rate is 6.25%. ABC has an outstanding credit record and has earned an AAA rating from the major credit rating agencies. The current interest rate on AAA corporate bonds is 6.45%. The historical risk premium for stocks over the risk-free rate of return is 5.5 percentage points. The firm’s beta is estimated to be 1.1 and its marginal tax rate, including federal, state, and local taxes is 40%.
a. What is the cost of equity?
b. What is the after-tax cost of debt?
c. What is the cost of capital?
Question 3:
Abbreviated financial statements are given for Fletcher Corporation in the following table:
2019 2020
Revenues $600.00 $690.00
Operating expenses 520 600
Depreciation 16 18
Earnings before interest and taxes 64 72
Less Interest Expense 5 5
Less: Taxes 23.6 26.8
Equals: Net income 35.4 40.2
Addendum:
Yearend working capital 150 200
Principal repayment 25 25
Capital expenditures 20 10
Yearend working capital in 2018 was $160 million and the firm’s marginal tax rate is 40% in both 2019 and 2020. Estimate the following for 2019 and 2020:
a. Free cash flow to equity.
b. Free cash flow to the firm.
Question 4:
No Growth Incorporated had operating income before interest and taxes in 2011 of $220 million. The firm was expected to generate this level of operating income indefinitely. The firm had depreciation expense of $10 million that same year. Capital spending totaled $20 million during 2011. At the end of 2010 and 2011, working capital totaled $70 and $80 million, respectively. The firm’s combined marginal state, local, and federal tax rate was 40% and its debt outstanding had a market value of $1.2 billion. The 10-year Treasury bond rate is 5% and the borrowing rate for companies exhibiting levels of creditworthiness similar to No Growth is 7%. The historical risk premium for stocks over the risk free rate of return is 5.5%. No Growth’s beta was estimated to be 1.0. The firm had 2,500,000 common shares outstanding at the end of 2011. No Growth’s target debt to total capital ratio is 30%.
a. Estimate free cash flow to the firm in 2011.
b. Estimate the firm’s cost of capital.
c. Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2011, assuming that it will generate the value of free cash flow estimated in (a) indefinitely.
d. Estimate the value of the equity of the firm at the end of 2011.
e. Estimate the value per share at the end of 2011.
Question 5:
Ergo Unlimited’s current year’s free cash flow is $10 million. It is projected to grow at 20% per year for the next five years. It is expected to grow at a more modest 5% beyond the fifth year. The firm estimates that its cost of capital is 12% during the next five years and then will drop to 10% beyond the fifth year as the business matures. Estimate the firm’s current market value.
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