Use the information for the question(s)below.
Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million,and this free cash flow is expected to grow at a rate of 3% per year thereafter.Flagstaff has an equity cost of capital of 13%,a debt cost of capital of 7%,and it has a 35% corporate tax rate.
-If Flagstaff currently maintains a debt to equity ratio of 1,then the value of Flagstaff as an all-equity firm would be closest to:

Question

Quizplus · Accepted Answer

Using the free cash flow to equity formula: FCFE = FCFF - (Interest expense * (1 - Tax Rate)) + Net Borrowing
Assuming that Flagstaff maintains a constant level of net borrowing and that the net borrowing is 0 in this case, we can simplify the formula to:
FCFE = FCFF - (Interest expense * (1 - Tax Rate))
FCFF = Free cash flow to firm = $8 million
Interest expense = Debt * Debt cost of capital = ($73 million - $73 million/1.35) * 7% = $3.5 million
So, FCFE = $8 million - ($3.5 million * (1 - 0.35)) = $6.225 million
To calculate the value of Flagstaff as an all-equity firm, we can use the Gordon growth model:
V = D / (k - g)
where V is the value of the firm, D is the expected dividend, k is the cost of equity, and g is the expected growth rate of dividends.
Assuming that Flagstaff pays out all of its FCFE as dividends, the expected dividend in year 1 would be $6.225 million.
k = Equity cost of capital = 13%
g = Expected growth rate of dividends = 3%
So, V = $6.225 million / (0.13 - 0.03) = $62.25 million
However, this is the value of equity in the all-equity firm. To get the value of the entire firm, we need to add back the value of debt:
Value of debt = Debt / (1 - Tax Rate) = $73 million / (1 - 0.35) = $112.31 million
Value of the firm = $62.25 million + $112.31 million = $174.56 million
So, the closest answer choice is C)$115 million.

Use the Information for the Question(s)below