A firm has 120 million shares at $10/share and $300 million in outstanding debt. Beta = 1.10, pre-tax cost of borrowing = 6%, Tc = 40%, Rf = 5%, Risk Premium = 4%.
a. Estimate the current cost of capital for the firm.
b. If the market is valuing the firm correctly today and the expected free cash flow to the firm next year is $80 million, estimate the implied growth rate in this cash flow in perpetuity.
c. You estimate the optimal debt ratio for the firm to be 40% and believe that the cost of capital will drop to 8%, if you move to the optimal by borrowing money and buying back shares. If you buy back the shares at $10.25/share, estimate the increase in value per share for the remaining shares.
d. The firm considering whether it should be reinvesting the funds from new debt back into the business, rather than buying back stock. Under which of the following circumstances does it make sense for it to make this switch? 1. Never. Buying back stock will always increase the stock price more than taking new investments. 2. Only if the new investments generate returns that exceed the after-tax cost of debt. 3. Only if the new investments generate returns that exceed the cost of capital at the existing debt ratio. 4. Only if the new investments generate returns that exceed the cost of capital at the new debt ratio. 5. Always, because the new investments will increase future growth.