Problem 1: Grommit Engineering expects to have net income next year of $20.75 million and free cash flow of $22.15 million. Grommit's marginal corporate tax is 35%.
a. If Grommit increases leverage so that its interest expense rises by $1 million, how will its net income change?
b. For the same increase in interest expense, how will free cash flow change?
Problem 2: Milton Industries expects free cash flow of $5 million each year. Milton's corporate tax rate is 35% and its unlevered cost of capital is 15%. The firm also outstanding debt of $19.05 million and it expects to maintain to maintain this level of debt permanently.
a) What is the value of Milton Industries without leverage?
b) What is the value of Milton Industries with leverage?
Problem 3: Kohwe Corporation plans to issue equity to raise $50 million to finance a new investment. After making the investment, Kohwe expects to earn free cash flows of $10 million each year. Kohwe currently has 5 million shares outstanding and it has no other assets or opportunities. Suppose the appropriate discount rate for Kohwe's future free cash flow is 8%, and the only capital market imperfections are corporate taxes and financial distress costs.
a) What is the NPV of Kohwe's investment?
b) What is Kohwe's share price today?
Suppose Kohwe borrows the $50 million instead. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $50 million on the loan. Suppose that Kohwe's corporate tax rate is 40%, and expected free cash flows are still $10 million each year.
c) What is Kohwe's share price today if the investment is financial with debt?
Now suppose that with leverage, Kohwe's expected free cash flows will decline to $9 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for Kohwe's future free cash flows is still 8%.
d) What is Kohwe's share price today given the financial distress costs of leverage?
Problem 4: Marpor Industries has no debt and expects to generate free cash flows of $16 million each year. Marpor believes that if it permanently increases its level of debt to $40 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a result, Marpor's expected free cash flows with debt will be only $15 million per year. Suppose Marpor's tax rate is 35%, the risk free rate is 5%, the expected return of the market is 15%, and the beta of Marpor's free cash flows is 1.10 (with or without leverage).
a) Estimate Marpor's value without leverage
b) Estimate Marpor's value with the new leverage