Question 4

Your manager wants you to help him value the Firm K and its equity and debt. The risk-free rate is 2% while the expected market return is 5%.

Firm K’s beta is 1.5. Firm’s K debt to equity is 1:1. Firm’s K cost of debt is 2.5% while its corporate tax rate is 30%. Its free cashflow for equity is $1 million per year. Interest expense is $50,000 per year with no Net borrowing. Successive cash flows (equity and firm) grow at 1% annually.

(a) Using Capital Asset Pricing Model (CAPM), calculate the cost of equity for Firm K.

(b) Calculate the Weighted Average Cost of Capital (WACC).

(c) How does the corporate tax reduce the overall WACC?

(d) Using free cash flow valuation methods, compute value of equity, firm and debt.