(a) Alpha Corporation has Year 0 cash flow of $500 million which is expected to

Question

(a) Alpha Corporation has Year 0 cash flow of $500 million which is expected to grow at 4% per year indefinitely. It has no debt currently. It is considering the following levels of debt (D) as proportion of debt plus equity (D-E) in first column of table below. Find the costs of capital for the 3 levels of debt: 096, 1096, and 20% (and show in column 4) and firm values for the three levels of debt(and show in column 5). Show all work below table. (15) st of EquityAfter-tax Cost of Debt Cost of CapitalFirm Value 10% 20% 7.50% 10.00% 12.50% 4.50% 5.50% 7.50% b) What level of debt will you recommend for the company, given the three scenarios? (5)

Explanation / Answer

Cost of capital (WACC) = Wd x Kd x (1 - tax) + We x Ke

here, W - weight, K - cost, e - equity, d - debt

Firm Value = FCF x (1 + g) / (WACC - g)

As the firm value is maximized when debt = 0%, we would recommend 0% debt level.

Debt % Ke Kd x (1 - T) WACC Firm Value 0% 7.50% 4.50% 7.50% $   14,857 10% 10.00% 5.50% 9.55% $     9,369 20% 12.50% 7.50% 11.50% $     6,933

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