Showboat Inc., a publicly traded gaming chain, is currently an all-equity financed firm. Barkshire Hatsaway is planning to acquire this firm to hold it in its portfolio of firms forever. Showboat is projected to earn a free cash flow of $50 million in year one. The free cash flow is expected to grow at a rate of 3% every year. Yesterday was the last day of year zero. Barkshire Hatsaway is planning to raise $300 million (net proceeds) in debt to help finance the acquisition. This debt will be added to Showboat’s balance sheet, just like in an LBO. The debt is a bullet loan that only pays interest for six years. At the end of year six, the last interest payment is made and the principal is repaid in full in one lump sum payment. The firm will return to being completely equity financed after year six. The interest rate charged on the debt is 6% and the risk-free rate is 2%. Flotation fees for issuing the debt are 2.5% of gross proceeds. Flotation fees can be amortized on a straight line basis over the six-year life of the debt. The corporate tax rate is 35%. Showboat’s unlevered cost of equity is 10%. If 30% of the firm’s assets were financed with debt, the firm’s cost of equity would be 11.1%.
a) Calculate Showboat’s firm value using the APV method.
b) How would your answer change if the firm’s year zero cash flow was $50 million (instead of the year one cash flow being equal to $50 million)? Assume the year zero cash flow was earned yesterday, the perpetual growth rate is still 3% and everything else stays the same. Calculate Showboat’s firm value given this change in cash flows.