Marpor Industries has no debt and expects to generate free cash flows of $17 mil

Question

Marpor Industries has no debt and expects to generate free cash flows of $17 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 $16 million per year. Suppose Marpor's tax rate is 30 %, the risk-free rate is 5%, the expected return of the market is 14 %, and the beta of Marpor's free cash flows is 1.1 (with or without leverage). a. Estimate Marpor's value without leverage. b. Estimate Marpor's value with the new leverage.

Explanation / Answer

a. Estimate Marpor's value without leverage.

Let us first calculate required rate of return on equity by CAPM

Required Return = Rf(Risk Free rate) + Beta (Risk Premium)

Required Return = 5% + 1.1 (14% - 5%) = 14.9%

Marpor's Value without leverage = 17,000,000/0.149 = $114,093,960.

b. Estimate Marpor's value with the new leverage.

Value of firm with debt = (16,000,000/0.149) + (0.30 * 40,000,000) = $107,382,550 + $12,000,000 = $119,382,550

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