Question

Acme Storage has a market capitalization of $100 million and debt outstanding of $40 million. Acme plans to maintain this same debt-equity ratio in the future. The firm pays an interest rate of 7.5% on its debt and has a corporate tax rate of 35%. show calculations
a. If Acme's free cash flow is expected to be $7 million next year and is expected to grow at a rate of 3% per year, what is Acme's WACC?
b. What is the value of Acme's interest tax shield?

Answer 1

Answer:

1. The Value of a levered firm can be calculated using WACC which means that if you have the Value, you can compute WACC.

The formula is;

Value of leveraged firm = Free cash-flow/ (WACC - Growth rate)

Value of leveraged firm = Value of Equity + Value of Debt

= 100 + 40

= $140 million

Value of leveraged firm = Free cash-flow/ (WACC - Growth rate)

140 = 7 ( WACC - 3%)

140 * WACC - 4.2 = 7

WACC = 0.08

= 8%

2. Interest tax shield = Value of leveraged firm - Value of unleveraged firm

Value of unleveraged Firm = Free Cash Flow/ WACC before tax - Growth rate

WACC before tax = WACC + (Debt/(Debt + Equity))*Cost of Debt*(Tax Rate)

= 8% + (40/ 140) * 7.5%(35%)

= 8.75%

Value of unleveraged  Firm = Free Cash Flow/ WACC before tax - Growth rate

= 7 /( 8.75% - 3%)

= $121.74 million

= $122 million

Interest tax shield = Value of leveraged firm - Value of unleveraged firm

= 140 - 122

= $18 million