Chapter 21, Problem 5MC

David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:

e. Suppose the expected free cash flow for Year 1 is $250,000 but it is expected to grow faster than 7% during the next 3 years: FCF₂ = $290,000 and FCF₃ = $320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is $128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be $152,000, at Year 3 it will be $192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.