EBK FINANCIAL MANAGEMENT: THEORY & PRAC
15th Edition
ISBN: 9781305886902
Author: EHRHARDT
Publisher: CENGAGE LEARNING - CONSIGNMENT
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Chapter 21, Problem 3P
Summary Introduction
To calculate: The value of the levered firm using compressed adjusted
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An unlevered firm has a value of $850 million. An otherwise identical but levered firm has $80 million in debt at a 3% interest rate, which is its pre-tax cost of debt. Its unlevered cost of equity is 10%. After Year 1, free cash flows and tax savings are expected to grow at a constant rate of 4%. Assuming the corporate tax rate is 25%, use the compressed adjusted present value model to determine the value of the levered firm. (Hint: The interest expense at Year 1 is based on the current level of debt.) Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places.
Happy Time Inc. is expected to generate the following cash flows for the next year, as shown in the table below. Happy Time now only has one outstanding debt with
a face value of $110 million to be repaid in the next year. The current market value for the debt is $67 million. The tax rate is zero. If the firm is financed by common
equity and debt, what is the expected value of common equity next year?
Cash flow in the next year
Probability Amount
Economy
Boom
0.3
$110 million
Normal
0.4
$101 million
Recession 0.3
$61 million
$26.8 million
$24.7 million
$0
-$18.3 million
Grommit Engineering expects to have net income next year of $24.36 million and free cash flow of $22.17
million. Grommit's marginal corporate tax rate is 35%.
a. If Grommit increases leverage so that its interest expense rises by $6.7 million, how will net income
change?
b. For the same increase in interest expense, how will free cash flow change?
a. If Grommit increases leverage so that its interest expense rises by $6.7 million, how will net income
change?
Net income will fall to $ 4.36 million. (Round to two decimal places.)
b. For the same increase in interest expense, how will free cash flow change? (Select the best choice
below.)
A. Free cash flow increases by the amount of the interest expense.
B. Free cash flow decreases by the amount of the interest expense.
C. Free cash flow is not affected by interest expense.
D. None of the above.
Chapter 21 Solutions
EBK FINANCIAL MANAGEMENT: THEORY & PRAC
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- Ogier Incorporated currently has $800 million in sales, which are projected to grow by 10% in Year 1 and by 5% in Year 2. Its operating profitability ratio (OP) is 10%, and its capital requirement ratio (CR) is 80%? What are the projected sales in Years 1 and 2? What are the projected amounts of net operating profit after taxes (NOPAT) for Years 1 and 2? What are the projected amounts of total net operating capital (OpCap) for Years 1 and 2? What is the projected FCF for Year 2?arrow_forwardHappy Time Inc. is expected to generate the following cash flows for the next year, as shown in the table below. Happy Time now only has one outstanding debt with a face value of $110 million to be repaid in the next year. The current market value for the debt is $67 million. The tax rate is zero. If you invest in the corporate debt of Happy Time Inc. today, what is your expected percentage return on this investment? Cash flow in the next year Economy Probability Amount Boom 0.3 Normal 0.4 Recession 0.3 O 36.87% O -26.37% 64.8% O-16.63% $110 million $101 million $61 millionarrow_forwardAn A firm has sales of $10 million, variable costs of $4 million, fixed expenses of $1.5 million, interest costs of $2 million, and a 30 percent average tax rate. a) Compute its DOL, DFL, and DCL. b) What will be the expected level of EBIT and net income if next year's sales rise 10 percent? c) What will be the expected level of EBIT and net income if next year's sales fall 20 percent?arrow_forward
- A firm will earn a taxable net return of $500 million next year. If it took on debt today, it would have to pay creditors\varepsilon(rDebt) = 5% + 10% x wDebt2. Thus, if the firm has 100% debt, the financial markets would demand 15% expected rate of return. Further, assume that the financial markets will lend the firm capital at this overall net cost of 15%, regardless of how the firm is financed. The firm is in the 25% marginal tax bracket. 1. If the firmis fully equity-financed, what is its value? 2. Using APV, if the firm is financed with equal amounts of debt and equity today, what is its value? 3. Using WACC, if the firm is financed with equal amounts of debt and equity today, what is its value? 4. Does this firm have an optimal capital structure? If so, what is its APV and WACC?arrow_forwardA company forecasts free cash flow of $400 at Year 1 and $600at Year 2; after Year 2, the FCF grow at a constant rate of 5%.The company forecasts the tax savings from interest deductionsas $200 in Year 1, $100 in Year 2; after Year 2, the tax savingsgrow at a constant rate of 5%. The unlevered cost of equityis 9%. What is the horizon value of operations at Year 2?($15,750.0) What is the current unlevered value of operations?($14,128.4) What is the horizon value of the tax shield at Year 2?($2,625.0) What is the current value of the tax shield? ($2,477.1)What is the levered value of operations at Year 0? ($16,605.5)arrow_forwardYour company faces a 30% tax rate and has $264 million in assets, currently financed entirely with equity. Equity is worth $9.40 per share, and a book value of equity is equal to the market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Pessimistic Optimistic Probability of State .30 .70 Expect EBIT in State $11.4 million $51.4 million The firm is considering switching to a 25-percent debt capital structure, and has determined that they would have to pay a 11 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? (Round your intermediate calculations and final answer to 2 decimal places, except calculation of number of shares which should be rounded to nearest whole number.)arrow_forward
- Krypton Engineering expects to have net profit next year of $28.18 million and free cash flow of $22.18 million. Krypton's marginal corporate tax rate is 40%. a. If Krypton increases leverage so that its interest expense rises by $8.1 million, how will its net profit change? b. For the same increase in interest expense, how will free cash flow change?arrow_forwardA company expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. The company has an equity cost of capital of 13%, a debt cost of capital of 7%, and it has a 35% corporate tax rate. If the company maintains a .5 debt to equity ratio, then what is Flagstaff's pre-tax WACC?arrow_forwardA company is financed with equity of $4.5 million and a bank loan of $2.5 million with an interest rate of 8.6% per annum. The EBIT is $1.12 million. The applicable tax rate is 19%. Use the above information to calculate the following: a) change in the return on equity and the degree of financial leverage given a 15% increase in EBIT next year, b) change in the return on equity and the degree of financial leverage given a 5% decrease in EBIT in the following year (the year following the year in which EBIT grew by 15%).arrow_forward
- Suppose a firm’s tax rate is 25%. 1. What effect would a $9.26 million operating expense have on this year's earnings? What effect would it have on next year's earnings? (Select all the choices thatapply.) A. A $9.26 million operating expense would be immediately expensed, increasing operating expenses by $9.26 million. This would lead to a reduction in taxes of 25%×$9.26 million=$2.32 million. B. A $9.26 million operating expense would be immediately expensed, increasing operating expenses by $9.26 million. This would lead to an increase in taxes of 25%×$9.26 million =$2.32 million. C. Earnings would decline by $9.26 million−$2.32 million=$6.94 million. The same effect would be seen on next year's earnings. D. Earnings would decline by $9.26 million−$2.32 million=$6.94 million. There would be no effect on next year's earnings. 2. What effect would a $11.75 million capital expense have on this year's earnings if the capital expenditure is depreciated at a rate of $2.35 million…arrow_forwardPlease solve the below with detailed explanationarrow_forwardGive typing answer with explanation and conclusion A company has an expected EBIT of $18,000 in perpetuity, a tax rate of 35%, and a debt-to- equity ratio of 0.75. The interest rate on the debt is 9.5%. The firm’s WACC is 9%. a) If the company has not debt, what would be the unlevered cost of capital and firm value? b) Suppose now the company has $55,714.29 in outstanding debt. Using your answer to part a) and M&M Proposition I with taxes, what is the value of this levered firm?arrow_forward
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