Holiday Trees Inc. is an unlevered (all-equity) firm that expects to generate an after-tax cash flow stream of $250 million next year and is expected to grow at a rate of 4% per year. The beta of the unlevered value of this free cash flow stream is 1.5. The riskless rate of interest is 6%, and the risk premium on the market portfolio is 7%. The corporate tax rate is 40%. Assume all debt is riskless. 1. What is the value of unlevered firm?2. The firm decides to lever itself to a 50% debt-to-equity ratio. Calculate WACC.3. Calculate value of the levered firm.

Answer and Explanation:

The computation is shown below:

1. Cost of equity = Risk free Rate + Beta × Market Risk Premium

= 6% + 1.5 × 7%

= 16.5%

Now Value of un Levered firm is

= After tax Cash flow year1 ÷ (Cost of Equity - Growth)

= $250 ÷ (16.5% - 4%)

= $2000

Beta levered  is

= Beta Unlevered (1+ (1- Tax Rate ) × Debt  ÷ Equity)

= 1.5  × (1 + (1  -40%) × 50% ÷ 100%

= 1.95

2.  Cost of equity = Risk free Rate + Beta × Market Risk Premium

= 6% + 1.95 × 7%

= 19.65%

Now WACC = Weight of Equity ×  Cost of Equity + Weight of debt × Cost of Debt × (1 - Tax rate)

=100% ÷ 150% × 19.65% + 50% ÷ 150% × 6% × (1 - 40%)

= 14.30%

3. Debt = 1 ÷ 3 × 2000

Value of levered firm = Value Unlevered + Debt × Tax Rate

= 2000 + 2000 ÷ 3 × 40%

= $2,266.67