Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common sharehold

Question

Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common shareholders’ equity at book value of $8,000. The market value of its common stock is $12,000 and the market value of its debt is the same as that on the balance sheet ($4,000). ROC's current market equity beta is 1.5. The risk-free rate in the economy is 3.5% and the market risk-reimium is 7%.

The firm faces 40% marginal tax rate. You are planning to to buy the firm with 50 percent common equity and 50 percent debt carrying an interest rate of 12 percent (the same as its current interest rate cost). Your forecasted free cash flow to both debt and equity stakeholders are given below. The free cash flows are expected to  grow 4 percent annually forever after Year 5.

What is the total value of ROC if go ahead with your proposed plan?

Year Free Cash Flow to Debt & Equity holders 1 $1,200 2 $1,560 3 $1,700 4 $1,980 5 $2,100

Explanation / Answer

Answer: $20,530

Step 1: Unlevering the Beta.

Unlevered Beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt/Equity)))

= 1.5/(1+0.6*1/3) = 1.25

Step 2: Relevering the beta to make debt equity ratio 1:1.

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.25 * (1+0.6*1) = 2

Step 3: Specific cost of capital:

After tax cost of debt = 12*0.6 = 7.2%

Cost of equity as per CAPM = Risk free rate + beta*market risk premium = 3.5 * 2*7 = 17.5%

Step 4: WACC:

7.2*0.5 + 17.5*0.5 = 12.35%

Step 5: Finding total value of ROC by discounting FCFF

Year FCF pvif @ 12.35% PV 1 1200 0.8901 1068 2 1560 0.7922 1236 3 1700 0.7051 1199 4 1980 0.6276 1243 5 2100 0.5586 1173 5919 Horizon value = (2100*1.04)/(0.1235 - 0.04) 26156 PV of horizon value = 26156*0.5586 14612 TOTAL VALUE OF ROC = 5919 + 14612 = 20530

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