May Department Stores (May) operates retail department store chains throughout the United States. At the end of

Question:

May Department Stores (May) operates retail department store chains throughout the United States. At the end of Year 12, May reports debt of $4,658 million and common shareholders’ equity at book value of $3,923 million. The market value of its common stock is $6,705, and its market equity beta is 0.88.

An equity buyout group is considering an LBO of May as of the beginning of Year 13. The group intends to finance the buyout with 25 percent common equity and 75 percent debt carrying an interest rate of 10 percent. The group projects that the free cash flows to all debt and equity capital stakeholders of May will be as follows: Year 13, $798 million; Year 14, $861 million; Year 15, $904 million; Year 16, $850 million; Year 17, $834 million; Year 18, $884 million; Year 19, $919 million; Year 20, $947 million; Year 21, $985 million; and Year 22, $1,034 million. The group projects free cash flows to grow 3 percent annually after Year 22.

This problem sets forth the steps the analyst might follow in deciding whether to acquire May and the value to place on the firm.

Required

a. Compute the unlevered market equity (asset) beta of May before consideration of the LBO. Assume that the book value of the debt equals its market value. The income tax rate is 35 percent.

b. Compute the cost of equity capital with the new capital structure that results from the LBO. Assume a risk-free rate of 4.2 percent and a market risk premium of 5.0 percent.

c. Compute the weighted average cost of capital of the new capital structure.

d. Compute the present value of the projected free cash flows to all debt and equity capital stakeholders at the weighted average cost of capital. Ignore the midyear adjustment related to the assumption that cash flows occur, on average, over the year. In computing the continuing value, apply the projected growth rate in free cash flows after Year 22 of 3 percent directly to the free cash flows of Year 22.

e. Assume that the buyout group acquires May for the value determined in Part d.

Assuming that the realized free cash flows coincide with projections, will May generate sufficient cash flow each year to service the interest on the debt? Explain.

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