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Schwarzentraub Industries' Case Study: MM Extension

Schwarzentraub Industries' expected free cash flow for the year is $500,000 in the future free cash flow is expected to grow at a rate of 9%. The company currently has no debt, and its cost of equity is 13%. Its tax rate is 40%.
a. Find Vu
b. Find VL and rsL is Schwarzentraub uses $5 million in debt with a cost of 7%. Use the extension of the MM model that allows for growth.
c. Based on Vu from part a, find VL and rsL,using the MM model (with taxes) if Schwarzentraub uses $5 million in 7% debt.
d. Explain the difference between your answers to parts b and c.

Solution Preview

a. Vu = FCF1/(Cost of equity - growth rate)
FCF1 = 500,000, cost of equity = 13% and growth rate = 9%
Vu = 500,000/(13%-9%) = $12,500,000

b. Under the MM extension model
VL = Vu + (Debt tax shield/(cost of equity - growth rate))
Debt tax shield = Debt amount X interest rate X tax rate = 5,000,000 X 7% X 0.4 = ...

Solution Summary

Schwarzentraub Industries' Case Study is examined. The cost of equity and cost of debt is determined. The MM model is examined for growth extensions.