Rosy Outlook Corporation (ROC) currently has debt of $4,000 and common sharehold
ID: 2740274 • Letter: R
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 present value of ROC's free cash flows to all debt and equity stakeholders in years 1 through 5 (do not include the continuation value)? Remember to use the relevant rate to find the present value.
Year Free Cash Flow to Debt & Equity holders 1 $1,200 2 $1,560 3 $1,700 4 $1,980 5 $2,100Explanation / Answer
Calculation of WACC:
After-tax Cost of debt = 12%(1-0.40) = 7.20%
Weighted cost of debt = 7.2 x 4000/ 16000 = 1.80%
Cost of equity = Rf + [Beta x Risk Premium]
= 3.5 + [1.50x7]
= 14%
Weighted cost of equity = 14 x 12000/ 16000 = 10.50%
WACC = 1.80 + 10.50 = 12.30%
NPV @ 12.30% = 1200/(1.123)1 + 1560/(1.123)2 + 1700/(1.123)3 + 1980/(1.123)4 + 2100/(1.123)5
= $5919
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