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Chapter 7 Questions

1. ABC Incorporated shares are currently trading for $30 per share. The firm has 1.4 billion shares
outstanding. In addition, the market value of the firm’s outstanding debt is $2.3 billion. The 10-year
Treasury bond rate is 6.45%. ABC has an outstanding credit record and has earned an AAA rating
from the major credit rating agencies. The current interest rate on AAA corporate bonds is 6.75%. The
historical risk premium for stocks over the risk-free rate of return is 5.2 percentage points. The firm’s
beta is estimated to be 1.2 and its marginal tax rate, including federal, state, and local taxes is 40%.

a. What is the cost of equity?


b. What is the cost of capital?
c. What is the weighted average cost of capital (WACC)?

a. COE = .0645 + 1.2 (.052) = .1269


b. (after-tax cost of debt) = .0675 x (1-.4) = .0405
c. WACC= ke*wt + kd*wt
wt = 30*1.4 = 42 (equity)
Wt = 2.3 (debt)
Total wt = 44.3
WACC = {(30x1.4)/44.3} x .1269 + {2.3/44.3} x .0405 = 0.122

2 No Growth Incorporated had operating income before interest and taxes in 2011 of $250 million. The
firm was expected to generate this level of operating income indefinitely. The firm had depreciation
expense of $12 million that same year. Capital spending totaled $15 million during 2011. At the end of
2010 and 2011, working capital totaled $60 and $70 million, respectively. The firm’s combined marginal
state, local, and federal tax rate was 40% and its debt outstanding had a market value of $1.5 billion. The
10-year Treasury bond rate is 5.5% and the borrowing rate for companies exhibiting levels of
creditworthiness similar to No Growth is 8%. The historical risk premium for stocks over the risk free
rate of return is 5.2%. No Growth’s beta was estimated to be 1.2. The firm had 2,500,000 common
shares outstanding at the end of 2011. No Growth’s target debt to total capital ratio is 35%.

a. Estimate free cash flow to the firm in 2011.


b. Estimate the firm’s cost of capital.
c. Estimate the value of the firm (i.e., includes the value of equity and debt) at the end of 2011,
assuming that it will generate the value of free cash flow estimated in (a) indefinitely.
d. Estimate the value of the equity of the firm at the end of 2011.
e. Estimate the value per share at the end of 2011.

a. Free cash flow to the firm in 2011 = 250x (1-.4) + 12–15 – (70-60) = 150 + 10 –20 –10 = $130 million
b. Cost of Capital (COE) = 5.5 + 1.0(.052) = 5.552
c. WACC = .6 x .552 + .08 x (1-.4) x .35 = 0.4112x0.21=0.0863
d. PV = 130,000,000/.0863 = 1506373117.03
e. Equity Value = $1,506.03 - $1,300.0 = $206.3 million
Equity value per share = 206.3/2.5 = $82.52

3 The following information is available for two different common stocks: company A and Company B.

Company A Company B
Free cash flow per share $1.30 $6.00
in the current year
Growth rate in cash flow 10% 3%
per share
Beta 1.5 .7
Risk-free return 6.5% 6.5%
Expected return on all 14.5% 14.5%
stocks

Sensitivity: Internal & Restricted


a. Estimate the cost of equity for each firm.
b. Assume that the companies’ growth rates will continue at the same rate indefinitely. Estimate
the per share value of each companies common stock.

Company A: 6.5 + 1.5 (14.5-10) = 6.5+6.75=13.25%


Company B: 6.5 + .7 (14.5-3) = 7 + 8.05 = 15.05%

Company A: P= $1.30 / (.132-.010) = $ 10.6557377


Company B: P=$6.00 / (.1505-.03) = $5.00/.082 =$49.7925311

4 Financial Corporation wants to acquire Great Western Inc. Financial has estimated the enterprise value
of Great Western at $110 million. The market value of Great Western’s long-term debt is $20 million,
and cash balances in excess of the firm’s normal working capital requirements are $5 million.
Financial estimates the present value of certain licenses that Great Western is not currently using to be
$5 million. Great Western is the defendant in several outstanding lawsuits. Financial Corporation’s
legal department estimates the potential future cost of this litigation to be $4 million, with an estimated
present value of $3.0 million. Great Western has 4 million common shares outstanding. What is the
value of Great Western per common share?

Answer: ($110 + $5 + $5 - $20 - $3.0) / 4 = 24.25 US$

Sensitivity: Internal & Restricted