Question

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 terms from its suppliers. As a​ result, Marpor's expected free cash flows with debt will be only $15 million per year. Suppose​ 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 1.1 ​(with or without​ leverage). a. Estimate​ Marpor's value without leverage. b. Estimate​ Marpor's value with the new leverage.

Answer 1

Answer and Explanation:

The computation is shown below:

a.  Marpor's value without leverage is

But before that first we have to calculate the required rate of return which is

The Required rate of return = Risk Free rate of return + Beta × market risk premium

= 5% + 1.1 × (15% - 5%)

= 16%

Now without leverage is

= Free cash flows generates ÷ required rate of return

= $16,000,000 ÷ 16%

= $100,000,000

b. And, with the new leverage is

= (Free cash flows with debt ÷ required rate of return) + (Tax rate × increase of debt)

= ($15,000,000 ÷ 0.16) + (0.35 × $40,000,000)

= $93,750,000 + $14,000,000

= $107,750,000