Chapter 18, Problem 13P

Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.20. Its current stock price is $50 per share, with 2.5 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.50 and can borrow at 4.20%, just 20 basis points over the risk-free rate of 4%. The expected return of the market is 10%, and PKGR’s tax rate is 35%.

1. a. This year, PKGR is expected to have free cash flows of $6.0 billion. What constant expected growth rate of free cash flow is consistent with its current stock price?
2. b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.50, it believes its borrowing costs will rise only slightly to 4.50%. If PKGR announces that it will raise its debt-equity ratio to 0.5 through a leveraged recap, determine the increase in the stock price that would result from the anticipated tax savings.