Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of ap

Question

Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.19. Its current stock price is $49 per share, with 2.5 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.475 and can borrow at 4.4%, just 20 basis points over the risk-free rate of 4.2%. The expected return of the market is 9.7%, and PKGR's tax rate is 32% a. This year, PKGR is expected to have free cash flows of $6.5 billion. What constant expected growth rate of free cash flow is consistent with its current stock price? b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.475, it believes its borrowing costs will rise only slightly to 4.7%. If PKGR announces that it will raise its debt-equity ratio to 0.475 through a leveraged recap, determine the increase or decrease in the stock price that would result from the anticipated tax savings

Explanation / Answer

Ke= Rf + (Rm - Rf) B Ke = 4.2 + (9.7 - 4.2)0.475 6.8125 Kd = cost of borrowing x (1-t) Kd=4.4(1-0.32) 2.992 Cost of capital [ke x E/D+E]+[kd x D/D+E] 6.8125x1/1.19 + 2.992x 0.19/1.19 6.202504 Value of firm = Current market price x no of shares 49x2.5 122.5 also, value of firm = FCFF1/kc-g therefore g=kc-(FCFF1/Value of firm) g = 0.062025 - (6.5/122.5) g 0.008964 i.e 0.89638% New Kc = 6.8125 x1/1.475 + 4.7(1-0.32) 0.475/1.475 4.618644 + 1.029220339 kc= 5.647864 Value of firm = FCFF1/kc-g 6.5/0.05647-0.008964 136.7994 Share Price = Value of firm/no. of shares 136.7994/2.5 54.71976 Increase in share price 5.71976 or 11.673% Please provide feedback…. Thanks In advance :-)

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