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# Financing and Valuations

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Interest tax shield benefit: Legitron Corporation has \$460 million of debt outstanding at an interest rate of 10 percent. If Legitron is subject to a 37 percent marginal tax rate, the amount of the tax shield on that debt for this year is \$ .

M&M Proposition 1: Marx and Spender has a current WACC of 20 percent. If the cost of debt capital for the firm is 14 percent and the firm is currently financed with 44 percent debt, the current cost of equity capital for the firm is %. Assume that all the assumptions of Modigliani and Miller Proposition 1 hold.

M&M Proposition 1: The weighted average cost of capital for a firm (assuming all three Modigliani and Miller assumptions) is 16 percent. If the firm's cost of debt is 9 percent and the proportion of debt to total firm value for the firm is 0.5, the current cost of equity capital for the firm is %. Assume that all the assumptions of Modigliani and Miller Proposition 1 hold.

M&M Proposition 2: Backwards Resources has a WACC of 12.1 percent, and it is subject to a 35 percent marginal tax rate. Backwards has \$293 million of debt outstanding at an interest rate of 12 percent and \$612 million of equity (market value) outstanding. The expected return of the equity given this capital structure is %.

(Round answer to two decimal places. Omit % sign in answer. All intermittent calculations should be rounded to 4 decimal places before carrying to next calculation.)

Income approaches: You are using the FCFF approach to value a business. You have estimated that the FCFF for next year will be \$123.65 million and that it will increase at a rate of 8 percent for each of the following three years. After that point, the FCFF will increase at a rate of 3 percent forever. If the WACC for this firm is 10 percent, the firm is worth \$ millions.

(Enter value in millions, rounded to 2 decimal places.)

A friend of yours is trying to value the equity of a company and, knowing that you have read this book, has asked for your help. So far she has tried to use the FCFE approach. She estimated the cash flows to equity to be as follows:
Sales \$800.0
-CGS -450.0
-Depreciation -80.0
-Interest -24.0
Earnings before taxes (EBT) 246.0
-Taxes (0.35 x EBT) -86.1
= Cash Flow to Equity \$159.9

She also computed the cost of equity using CAPM as follows:
kE = kF + bE(Risk premium) = 0.06 + (1.25 x 0.084) = 0.165, or 16.5%

where the beta is estimated for a comparable publicly traded company. Using this cost of equity, she estimates the discount rate as

WACC = x_Debtk_Debt pretax(1 - t) + xcskcs

Based on this analysis, she concludes that the value of equity is \$159.9 million/0.14 = \$1,142 million.

Assuming that the numbers used in this analysis are all correct, what advice would you give your friend regarding her analysis?

#### Solution Preview

Interest tax shield benefit: Legitron Corporation has \$460 million of debt outstanding at an interest rate of 10 percent. If Legitron is subject to a 37 percent marginal tax rate, the amount of the tax shield on that debt for this year is \$ .

Show Work is REQUIRED for this question
M&M Proposition 1: Marx and Spender has a current WACC of 20 percent. If the cost of debt capital for the firm is 14 percent and the firm is currently financed with 44 percent debt, the current cost of equity capital for the firm is %. Assume that all the assumptions of Modigliani and Miller Proposition 1 hold.

Show Work is REQUIRED for this question
M&M Proposition 1: The weighted average cost of capital for a firm (assuming all three Modigliani and Miller assumptions) is 16 percent. If the firm's cost of debt is 9 percent and the proportion of debt to total firm value for the firm is 0.5, the current cost of equity capital for the firm is %. Assume that all the assumptions of Modigliani and Miller Proposition 1 hold.

Show Work is REQUIRED for this question
M&M Proposition 2: Backwards Resources has a WACC of 12.1 percent, and it is subject to a 35 percent marginal tax rate. Backwards has \$293 million of debt outstanding at an interest rate of 12 percent and \$612 million of ...

#### Solution Summary

Solution helps in discussing the weighted average cost of capital for a firm (assuming all three Modigliani and Miller assumptions) is 16 percent. If the firm's cost of debt is 9 percent and the proportion of debt to total firm value for the firm is 0.5, the current cost of equity capital for the firm is %. Assume that all the assumptions of Modigliani and Miller Proposition 1 hold.

\$2.19

## Finance Valuation: Stock Value, Discount Rate, Required Return

1. Doctors-On-Call, a newly formed medical group, just paid a dividend of \$1.50. The company's dividend is expected to grow at a 20% rate for the next 3 years and at a 3% rate thereafter. What is the value of the stock if the appropriate discount rate is 12%?

2. Bill Bailey and Sons pays no dividend at the present time. The company plans to start paying an annual dividend in the amount of \$.30 a share for two years commencing two years from today. After that time, the company plans on paying a constant \$1 a share dividend indefinitely. How much are you willing to pay to buy a share of this stock if your required return is 14%?

3. Schnusenberg Corporation just paid a dividend of \$0.65 per share, and that dividend is expected to grow at a constant rate of 7.00% per year in the future. The company's beta is 0.95, the required return on the market is 10.50%, and the risk-free rate is 5.00%. What is the company's current stock price?

4. A company forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?

Year: 1 2 3
Free cash flow: -\$15 \$10 \$40

5. Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -\$10 million, but its FCF at t = 2 will be \$20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever.

Its balance sheet shows

- \$65 million in accounts receivable,
- \$45 million in inventory,
- \$43 million in short-term investments that are unrelated to operations,
- \$20 million in accounts payable,
- \$95 million in long-term debt,
- \$25 million in preferred stock,
- \$40 million in retained earnings, and \$
- 130 million in total common equity.

If the weighted average cost of capital is 14%, what is the firm's value of operations, in millions?

If the company has 30 million shares of stock outstanding, what is the best estimate of the stock's price per share?

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