Flagstaff Enterprises is expected to have free cash flows in the coming year of

Question

Flagstaff Enterprises is expected to have free cash flows in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and is in the 35% corporate tax bracket.
(a) If Flagstaff maintains a .5 debt to equity ratio, then Flagstaff’s pre-tax WACC is closest to:

(1) 10.5%
(2) 11.0%
(3) 9.0%
(4) 10.0%


(b) If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff as an all equity firm would be closest to:

(1) $80 million
(2) $100 million
(3) $73 million
(4) $115 million


(c) If Flagstaff currently maintains a .5 debt to equity ratio, then Flagstaff’s after-tax WACC is closest to:

(1) 10%
(2) 10.25%
(3) 9.50%
(4) 8.75%

Explanation / Answer

(a) WACC = E*Ks/(E+d) + D*Kd/(E+D) where Ks & Kd are cost of capital & cost of Debt resp and Debt/Equity Rati = D/E = 0.5 ie D = 0.5E So WACC = E*13%/(E+0.5E) + 0.5E*7%/(E+0.5E) ie WACC = 13%/1.5 + 0.5*7%/1.5 = 11.00%..............Ans (2) (b) So Value of Firm = FCF/(WACC-g) = $80M/(11%-3%) = $100M....Ans (2) (c) Post Tax WACC = E*Ks/(E+d) + D*Kd*(1-T)/(E+D) So WACC = E*13%/(E+0.5E) + 0.5E*7%*(1-35%)/(E+0.5E) ie WACC = 13%/1.5 + 0.5*7%*(1-35%)/1.5 = 10%........................Ans (1)

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