Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of ap
ID: 2799814 • Letter: P
Question
Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.15. Its current stock price is $54 per share, with 2.3 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.375 and can borrow at 4.0%, just 20 basis points over the risk-free rate of 3.8%. The expected return of the market is 10.3%, and PKGR's tax rate is 32%.
Please answer the following:
a. This year, PKGR is expected to have free cash flows of $6.3 billion. What constant expected growth rate of free cash flow is consistent with its current stock price?
The constant expected growth rate of free cash flow consistent with its current stock price is ____% (round to two decimal places)
b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.375, it believes its borrowing costs will rise only slightly to 4.3%. If PKGR announces that it will raise its debt-equity ratio to 0.375 through a leveraged recap, determine the increase or decrease in the stock price that would result from the anticipated tax savings.
Increase (or decrease) in stock price is $____ (round to the nearest cent)
Explanation / Answer
a)
Wd = 0.15/1.15 = 13.04%
We = 1 - 13.04% = 86.96%
Re = 3.8% + 0.375*(10.3% - 3.8%) = 6.24%
Rd = 4%
WACC = 13.04%*4%*(1-32%) + 86.96%*6.24% = 5.78%
equity = 54*2.3 = 124.2
Debt = 0.15*124.2 = 18.63
firm value = 18.63 + 124.2 = 142.83
firm value = 6.3 / (5.78%-g)
6.3/ (5.78%-g) = 142.83
6.3 = 8.25 - 142.83*g
g = (8.25 - 6.3) / 142.83
g = 1.37%
b)
Wd = 0.375 / 1.375 = 27.27%
We = 1 - Wd = 72.73%
R(unlevered) = 13.04%*4% + 86.96%*6.24% = 5.95%
Re = 5.95% + 0.375*(5.95% - 4.3%) = 6.57%
Rd = 4.3%
WACC = 27.27%*4.3%*(1-32%) + 72.73%*6.57% = 5.57%
Value = 6.3 / (5.57% - g) = 6.3 / (5.57% - 1.37%) = 121.20
Loss = 121.20 - 142.83 = -21.63
Per share loss = -21.63 / 2.3 = -9.40
new share price = 54 - 9.40 = 44.60
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