Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million and this

QUESTION

Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this freecash flow is expected to grow at a rate of 3% per year perpetually. Flagstaff has an equity cost ofcapital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket. If Flagstaffcurrently maintains a 0.8 debt to equity ratio, calculate the value of Flagstaffs interest tax shield. Hint:Use pre-tax WACC to calculate VU and after-tax WACC to calculate VL.
Solution Given Cost of equity 13% Cost of debt 7% Tax rate 35% Debt to equity ratio = 0.8 Free cash flow in year 1 = $8mn Long term growth rate, g = 3% Workings Cost of debt (post-tax) 7%*(1-35%) = 4.55% Debt to total capital = 0.8/(0.8+1) = 44.44% Equity to total capital = 1-44.44% = 55.56% WACC = 13%*55.56^ + 4.55%*44.44% WACC = 9.24% Equity valuation = (CF(year

)*(1+g)/(WACC g) = [8/(9.24% 3%)] Equity valuation = $128.12 Based on Debt to equity ratio of 0.8, debt would be 0.8*equity value i.e. 0.8*128.12 = 102.48 Cost of debt = 7% Interest expense = 102.48*7% = $7.17 million Tax shield = 7.17*35% = $2.51 million.

ANSWER:

CLICK REQUEST FOR  AN EXPERT SOLUTION