HW2
Berden Inc. currently has an asset base of P100,000. It expects a constant pre-tax return of 20% on its current investments and on its future investment opportunities (in perpetuity). These growth opportunities require Berden to maintain an investment ratio of 25% of after-tax operating cash flow (i.e., in new investments, net of replacement investments which are assumed equal to depreciation). The corporate income tax rate is 30 %.
The risk-free rate is 5% and the expected return on the market portfolio is 14%. Berden has an asset beta of 0.80. The tax rates on income from debt and equity investments is such that T=0, i.e., corporate debt has a neutral tax effect on value.
Suppose Berden were to adopt all-equity financing:
1. Determine the free cash flow to the firm (FCFF) of Berden in year 1
2. Determine its cost of unlevered equity (ku) and its intrinsic value at time 0.
3. Is Berden creating value for its shareholders? By how much?
Consider an alternative capital structure where Berden funds all investments at a 50:50 proportion between debt and equity. Berden’s debt will carry an interest rate of 6.575 %.
4. Berden’s levered beta (βe) is 1.263. What is Berden’s cost of levered equity? Compare this to the cost of unlevered equity, i.e., in the all-equity structure. What is the additional risk premium for?
5. On a market-value weighted basis, the proportion of debt is 40% and that of equity is 60%. Determine the WACC of Berden’s levered capital structure.
6. What is Berden’s overall firm value (VL) with this capital structure? Estimate the intrinsic value of its equity and the gain to shareholders under this structure.
The risk-free rate is 5% and the expected return on the market portfolio is 14%. Berden has an asset beta of 0.80. The tax rates on income from debt and equity investments is such that T=0, i.e., corporate debt has a neutral tax effect on value.
Suppose Berden were to adopt all-equity financing:
1. Determine the free cash flow to the firm (FCFF) of Berden in year 1
2. Determine its cost of unlevered equity (ku) and its intrinsic value at time 0.
3. Is Berden creating value for its shareholders? By how much?
Consider an alternative capital structure where Berden funds all investments at a 50:50 proportion between debt and equity. Berden’s debt will carry an interest rate of 6.575 %.
4. Berden’s levered beta (βe) is 1.263. What is Berden’s cost of levered equity? Compare this to the cost of unlevered equity, i.e., in the all-equity structure. What is the additional risk premium for?
5. On a market-value weighted basis, the proportion of debt is 40% and that of equity is 60%. Determine the WACC of Berden’s levered capital structure.
6. What is Berden’s overall firm value (VL) with this capital structure? Estimate the intrinsic value of its equity and the gain to shareholders under this structure.