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Finance: Marpor's value using leverage; Raise funds but retain 50% equity

1. Marpor Industries has no debt and expects to generate free cash flows of $16 million each year. Marpor believes that if it permanently increases its level of debt to $40 million, the risk of financial distress may cause it to lose some customers and receive less favorable term from its suppliers. As a result, Marpor's tax rate is 35%, the risk-free rate is 5%, the expected return of the market is 15%, and the beta of Marpor's free cash flows is 1.10 (with or without leverage).

a) Estimate Marpor's value without leverage.
b) Estimate Marpor's value with the new leverage.

2. You own your own firm, and you want to raise $30 million to fund and expansion. Currently you own 100% of the firm's equity, and the firm has no debt. To raise the $30 million solely through equity, you will need to sell two-thirds of the firm. However, you would prefer to maintain at least a 50% equity stake in the firm to retain control.

a) If you borrow $20 million, what fraction of the equity will you need to sell to raise the remaining $10 million? (Assume perfect capital markets)
b) What is the smallest amount you can borrow to raise the $30 million without giving up control? (Assume perfect capital markets).

Solution Preview

a) Without leverage, the value is the present value of free cash flows discounted at the cost of equity. Using CAPM
Cost of equity = Rf + (Rm-Rf) beta
Rf = risk free rate = 5%
Rm= return on market = 15%
beta = 1.10
Cost of equity = 5% + (15%-5%) 1.10 = 16%
Free cash flows are $16 million per year. Since this is a perpetuity, the PV is calculated as
PV = Annual ...

Solution Summary

The solution explains two finance questions relating to value using leverage and raise funds but retain 50% equity