Company IC2S is expected to earn £1250 and £1530 before interest and taxes in year 2021 and 2022. The market expects these earnings to grow at a rate of 2.8% per year after 2022. The firm will make no net investments in long-term capital (i.e., capital expenditures will equal depreciation of long-term assets) nor changes to net working capital. It has debt of £3250 at the end of 2020 with before-tax cost of debt of 3.5%. The debt for the next two years is expected to be £3300 and £3392.40. It then grows by 2.8% to keep a constant ratio of debt to equity every year. Assume that the corporate tax rate equals 22.5%. Suppose the risk-free rate equals 1.7%, and the expected return on the market equals 7.1%. The asset beta for this industry is 1.30.   Estimate the unlevered cost of equity capital assuming the firm’s asset beta equals its industry beta. Estimate the firm level free cash flows at the end of 2021-2023. If IC2S were an all-equity (unlevered) firm, estimate its market value at the end of 2021 and 2022. Assuming the debt is fairly priced and the future interest payments have the same beta as IC2S assets, calculate the present value of IC2S’interest tax shield at the end of 2021 and 2022. Estimate the market value of the firm and its equity at the end of 2021. Calculate the firm’s WACC and cost of equity in 2021. Assuming that the proceeds from any increases in debt are paid out to equity holders, estimate cash flows that the equity holders (FCFE) expect to receive in 2021 and 2022.

Question

Company IC2S is expected to earn £1250 and £1530 before interest and taxes in year 2021 and 2022. The market expects these earnings to grow at a rate of 2.8% per year after 2022. The firm will make no net investments in long-term capital (i.e., capital expenditures will equal depreciation of long-term assets) nor changes to net working capital. It has debt of £3250 at the end of 2020 with before-tax cost of debt of 3.5%. The debt for the next two years is expected to be £3300 and £3392.40. It then grows by 2.8% to keep a constant ratio of debt to equity every year. Assume that the corporate tax rate equals 22.5%. Suppose the risk-free rate equals 1.7%, and the expected return on the market equals 7.1%. The asset beta for this industry is 1.30.

 

  1. Estimate the unlevered cost of equity capital assuming the firm’s asset beta equals its industry beta.
  2. Estimate the firm level free cash flows at the end of 2021-2023.
  3. If IC2S were an all-equity (unlevered) firm, estimate its market value at the end of 2021 and 2022.
  4. Assuming the debt is fairly priced and the future interest payments have the same beta as IC2S assets, calculate the present value of IC2S’interest tax shield at the end of 2021 and 2022.
  5. Estimate the market value of the firm and its equity at the end of 2021.
  6. Calculate the firm’s WACC and cost of equity in 2021.
  7. Assuming that the proceeds from any increases in debt are paid out to equity holders, estimate cash flows that the equity holders (FCFE) expect to receive in 2021 and 2022.

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