You have been asked by Med Parts Inc, a medical device maker, for advice on whether they
Question:
You have been asked by Med Parts Inc, a medical device maker, for advice on whether they are using the right mix of debt and equity to fund their operations. The firm has 120 million shares trading at $5 a share and $ 400 million in outstanding debt. The current levered beta for the firm is 1.2 and the pre-tax cost of borrowing is 5%. The marginal tax rate is 40%, the risk-free rate is 3% and the equity risk premium is 4%.
a) If the market is valuing the firm correctly today (i.e., market value = fundamental value) and the expected free cash flow to the firm next year is $ 40 million, estimate the implied growth rate in this cash flow in perpetuity given the company’s cost of capital.
b) You estimate the optimal debt ratio for the firm to be 50% and believe that the cost of capital will drop to 5.5% if you move to the optimal by borrowing money and buying back shares. If you buy back the shares at $5.25/share, estimate the increase in value per share for the remaining shares.
