May operates retail department store chains throughout the United States. Assume that at the end of Year

Question:

May operates retail department store chains throughout the United States. Assume that at the end of Year 2, May's balance sheet 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.

Suppose an equity buyout group is considering an LBO of May as of the beginning of Year 3. The group intends to finance the buyout with 25% common equity and 75% debt carrying an interest rate of 10%. Assume the group projects that the free cash flows to all debt and equity capital stakeholders of May will be as follows: Year 3, $798 million; Year 4, $861 million; Year 5, $904 million; Year 6, $850 million; Year 7, $834 million; Year 8, $884 million; Year 9, $919 million; Year 10, $947 million; Year 11, $985 million; and Year 12, $1,034 million. The group projects free cash flows to grow 3% annually after Year 12.

This problem sets forth the steps you 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%. (See Chapter 11.)

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% and a market risk premium of 5.0%.

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 12 of 3% directly to the free cash flows of Year 12.

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

Common Stock
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Balance sheet is a statement of the financial position of a business that list all the assets, liabilities, and owner’s equity and shareholder’s equity at a particular point of time. A balance sheet is also called as a “statement of financial... Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a... Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of... Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the...