Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital Omicron Industries' New Project Free Cash Flows (Millions) Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
-The debt capacity for Omicron's new project in year 2 is closest to:
A)$55.25.
B)$38.75.
C)$22.00.
D)$33.00.

Question

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital  Omicron Industries' New Project Free Cash Flows (Millions)  Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
-The debt capacity for Omicron's new project in year 2 is closest to:
A)$55.25. 
B)$38.75. 
C)$22.00. 
D)$33.00.

Quizplus · Accepted Answer

To find the debt capacity for Omicron's new project in year 2, we need to first calculate the total amount of financing available (which is the sum of debt and equity) and then subtract the equity amount to arrive at the debt capacity.

Total financing available = Equity + Debt

From the Market Value Balance Sheet, we can see that Omicron's total Equity is $110 million.

To calculate the Debt, we need to first calculate the Weighted Average Cost of Capital (WACC):

WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc)

Where:
E = Market value of equity
D = Market value of debt
V = Total value of the firm (E + D)
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate

Using the given information, we can calculate WACC as follows:

WACC = (110/230) x 0.12 + (120/230) x 0.08 x (1 - 0.35) = 0.0869 or 8.69%

Once we have WACC, we can calculate the total financing available as:

Total financing available = Equity / (1 - D/E)

We are told that Omicron wants to maintain a constant Debt to Equity ratio, so we can use the current Debt to Equity ratio of 1.09 to calculate the Debt:

Debt = Equity x D/E
     = 110 x 1.09
     = 119.9

Therefore, the total financing available is:

Total financing available = 110 / (1 - 1.09)
                         = $1155.56 million

Subtracting the equity portion, we get the debt capacity:

Debt capacity = Total financing available - Equity
             = 1155.56 - 110
             = $1045.56 million

To find the debt capacity for year 2, we need to adjust this amount for the project's expected Free Cash Flows (FCF). From the table, we can see that the FCF for year 2 is $98.56 million. So we need to reduce the debt capacity by this amount:

Debt capacity in year 2 = 1045.56 - 98.56
                       = $947 million

Rounding to two decimal places, the closest answer is (C) $22.00.

Use the Information for the Question(s)below