The following information has been presented to you about the Gibson Corporation
ID: 2614312 • Letter: T
Question
The following information has been presented to you about the Gibson Corporation: Total assets = $3,000 million; Tax rate = 40%; Operating income (EBIT) = $800 million; Debt ratio = 0%; Interest expense = $0 million; WACC = 10%; Net income = $480 million; M/B ratio = 1.00x; Share price = $32.00; EPS = DPS = $3.20. The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (thus, EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm?
Explanation / Answer
ANSWER = $4800 MILLION
1) NEW WACC =
WACC = wc *rs+ wd * rd (1 - tax rate)
= [0.8 * (0.11) ] + [0.2 * (1 - 0.4) * 0.10] = 0.10
2) Free cash flow: Because there is no growth, there is no investment in capital, hence FCF is equal to NOPAT:
FCF = NOPAT - Investment in capital
= EBIT(1 - T) - 0
= $800(1 - 0.4) = $480 million.
3) New value of the firm:
V = FCF/(WACC - g)
= $480 / 0.10 = $4,800 million
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