Cash flow from assets (CFFA) was $500 last year, of which interest expense was $75 and will continue forward at $75 indefinitely. (Retiring any interest-bearing debt would eliminate this $75 charge…) You expect CFFA to grow by 10% next year, 5% the following year, and then 3% forever each year starting in year 3, going forward. The risk free rate is 2.8%. The Equity Risk Premium is 6.7%. Beta for this firm is 1.7. The cost of debt capital is 6%. D/E is 0.5. The tax rate is 35%. Interest Bearing Debt is $1,000.
1. What is the cost of equity capital for the company?
2. What is the Weighted Average Cost of Capital for the company?
3. What is CFFA expected to be in year 3?
4. What is the geometric growth rate of the cash flow over the first three years?
5. What is the value of the Assets?
6. What is the value of the Equity?
7. If you are planning to buy this firm using the information above relative to this problem, and you are offered to buy the firm in exchange for retiring the face value of interest-bearing debt ($1,000), should you buy it? [HINT: In this question, because you have retired the IBD, your cost of capital will be the cost of equity as you will no longer have debt. Further, you will use Cash Flow to Equity for your cash flow numbers.]
8. If you buy it for $1,000 (retiring the debt), what would the payback be, measured in years?