Suppose that company ABC has the following free cash flows and market values of debt projected...

 

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Suppose that company ABC has the following free cash flows and market values of debt projected for the next year (right now it is year 0): Year: Free cash Flows 0 1 500 Debt 600 900 After year 1, the company projects that cash flows will grow at a rate of 1% each year. After year 1, ABC intends to keep its debt level constant at 900. ABC has a cost of debt of 4%. ABC has a close competitor which has an equity beta of 1.2 and a leverage (D/V) ratio of 50%. The competitor's debt has a yield to maturity is 4.8%. The competitor's debt is A-rated, which implies that its probability of default is 5%. You estimate that the loss rate in the event of default is 10%. The expected market return is 10%, the risk-free rate is 2%, and the corporate tax rate is 35%. (a) What is the cost of equity and cost of debt of the competitor? What is an estimate of ABC's unlevered cost of capital? (b) Calculate the unlevered value of ABC in year 0 and year 1. (c) What is the present value of ABC's tax shield as of year 0 and year 1? (d) What is the levered value of ABC in year 0 and year 1? Suppose that company ABC has the following free cash flows and market values of debt projected for the next year (right now it is year 0): Year: Free cash Flows 0 1 500 Debt 600 900 After year 1, the company projects that cash flows will grow at a rate of 1% each year. After year 1, ABC intends to keep its debt level constant at 900. ABC has a cost of debt of 4%. ABC has a close competitor which has an equity beta of 1.2 and a leverage (D/V) ratio of 50%. The competitor's debt has a yield to maturity is 4.8%. The competitor's debt is A-rated, which implies that its probability of default is 5%. You estimate that the loss rate in the event of default is 10%. The expected market return is 10%, the risk-free rate is 2%, and the corporate tax rate is 35%. (a) What is the cost of equity and cost of debt of the competitor? What is an estimate of ABC's unlevered cost of capital? (b) Calculate the unlevered value of ABC in year 0 and year 1. (c) What is the present value of ABC's tax shield as of year 0 and year 1? (d) What is the levered value of ABC in year 0 and year 1?

Answer rating: 100% (QA)

a To calculate the cost of equity and cost of debt of the competitor we first need to determine the ... View the full answer