Question

As a consultant to CSUSM, you have obtained the following data (dollars in millions). The company plans to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because growth is zero. The CFO believes that a move from zero debt to 70.0% debt would cause the cost of equity to increase from 9.0% to 12.0%, and the interest rate on the new debt would be 8.5%. What would the firm's total market value be if it makes this change?

Answer 1

Answer:

$6,694.56 million

Explanation:

EBIT = $800

corporate tax = 40%

the company's intrinsic value = FCF / (WACC - g)

since g = 0, then the intrinsic value = FCF / WACC

first we need to determine the free cash flow and then the WACC to determine the intrinsic value of the company:

• FCF = $800 x (1 - 40%) = $480
• WACC = (30% x 12%) + [70% x 8.5% x (1 - 40%)] = 3.6% + 3.57% = 7.17%

company's intrinsic value = $480 / 7.17% = $6,694.56