Question

Sallie's Sandwiches Sallie's Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4. Sallie's beta is 2.0, and its tax rate is 34%. The risk-free rate is 8%, and the market risk premium is 4%. 13. Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings? a. 12.0% b. 13.9% c. 14.4% d. 16.0% e. 16.9%

ANSWER: rsL = 8% + 2.0(4%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%.

here the answer i dont understand how in this equation rsU = 0.20(8%) + 0.80(16%) = 14.4%. , .80 was obtained

Answer 1

rsU = 0.20(8%) + 0.80(16%)

= 14.4%

Since in this question, it is given that

Debt = 20%

A company's capital structure comprises two factor, Equity & Debt or we can say

Debt + Equity = 100% Capital Structure

Therefore, Equity = 100%-20%

= 80% or 0.80

So, Debt = 20% or 0.20

Risk free rate = Return from Debt = 8% or 0.08

Equity = 80% or 0.8

Return from Equity = rSL = 16% or 0.16