McKenzie, Inc., reported EBIT of $8.5 million for last year. Depreciation expense totaled $5 million and capital expenditures came to $2 million. Free cash flow is expected to grow at a rate of 2.5% for the foreseeable future. McKenzie faces a 21 percent tax rate and has a .50 debt to equity ratio with $20 million (market value)in debt outstanding. McKenzie's equity beta is 1.4, the risk-free rate is currently 5 percent and the market risk premium is estimated to be 7.5 percent. McKenzie has 10 million shares of common stock outstanding. What is the current value of a share of McKenzie stock (in millions)?

Question

Quizplus · Accepted Answer

First, calculate the unlevered beta (βu) using the formula: βu = βe / [1 + ((1 - tax rate) * (Debt/Equity))], where βe is the equity beta. βu = 1.4 / [1 + ((1 - 0.21) * 0.5)] = 1.4 / 1.395 = 1.0036. Next, calculate the cost of equity (Re) using the CAPM formula: Re = Risk-free rate + βu * Market risk premium. Re = 5% + 1.0036 * 7.5% = 5% + 7.527% = 12.527%. Then, calculate the after-tax operating income (NOPAT): NOPAT = EBIT * (1 - tax rate) = $8.5 million * (1 - 0.21) = $6.715 million. Calculate the Free Cash Flow (FCF): FCF = NOPAT + Depreciation - Capital Expenditures = $6.715 million + $5 million - $2 million = $9.715 million. Finally, calculate the value of the firm using the Gordon Growth Model for FCF: Value = FCF / (Re - g) = $9.715 million / (0.12527 - 0.025) = $9.715 million / 0.10027 = $96.88 million. To find the value per share, divide the firm value by the number of shares: Value per share = $96.88 million / 10 million shares = $9.688, rounded to $9.76.