Question

Reliable Corp. currently has expected FCFs of $60 million per year, which are expected to continue forever. The first cash flow will occur one year from today. The firm has committed to keep a constant D/E ratio of 1.5. The firm’s unlevered (or asset) cost of capital (ru) is 12%. The firm’s debt has a yield of 6%. The debt has a probability of default of 2% and a loss given default of 50%. The corporate tax rate is 25%. a. What is the total value of Reliable Corp (what is the PV of Reliable Corp’s FCFs)? b. How much of this value is due to the firm’s decision to have debt in its capital structure (as opposed to being an all equity firm)?

Answer 1

First, let us calculate the weights of debt and equity in the firm's balance sheet

The debt to equity ratio of the company is 1.5 which mean debt is 1.5 times of equity.

Debt = 1.5 * Equity

If Debt + Equity = 100%

Than Debt = 60% and Equity = 40%

Cost of Debt

Pre Tax Yield on Bonds = 6%

Tax Rate = 25%

Post Tax Yield on Bonds = Pre Tax Yield * (1-Tax Rate) = 6% * (1-25%) = 4.5%

Post Tax Cost of Debt = 4.5%

Cost Equity = 12%

WACC = Weight of Debt * Cost of Debt + Weight of Equity * Cost of Equity

= 60% * 4.5% + 40% * 12% = 7.5%

WACC of the firm = 7.5%

a. Total Value of Firms FCFF

Cash Flow appearing every year = $60 million

WACC = 7.5%

Firm's Value = Cash Flow/WACC = $60million/7.5% = $800 million

Value of the Firm's FCFF is $800 million

b. Total Value of Firm's FCFF if the firm is all-equity firm

Cash Flow appearing every year = $60 million

WACC = Cost of Equity = 12%

Firm's Value = Cash Flow/WACC = $60million/12% = $500 million

Value of the Firm's FCFF when firm is all equity firm is $500 million

Value of the firm due to debt = Value of the firm with debt - Value of all equity firm = $800 - $500 = $300 million

Value of firm due to debt = $300 million