Question

Luther Industries has no debt and expects to generate free cash flows of $48 million each year. Luther believes that if it permanently increases its level of debt to $100 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a result, Luther's expected free cash flows with debt will be only $44 million per year. Suppose Luther's tax rate is 40%, the risk-free rate is 6%, the expected return of the market is 14%, and the beta of Luther's free cash flows is 1.25 (with or without leverage). The value of Luther with leverage is closest to:_______.
A) 11.5%.
B) 10.8%.
C) 9.8%.
D) 13.0%.

Answer 1

Answer: $315 million

Explanation:

First find the cost of capital as a required rate of return using CAPM:

= Risk free rate + Beta * (Market return - Risk free rate)

= 6% + 1.25 *(14% - 6%)

= 16%

Value of Luther with leverage:

= (Cash flows with debt / required return) + (Debt * Tax)

= (44 million / 16%) + (100 million * 40%)

= $315 million

Options do not represent value.