Sallie's Sandwiches
Sallie's Sandwiches is financed using 20% debt at a cost of 8%.Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4.(The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4.Sallie's beta is 2.0, and its tax rate is 25%.The risk-free rate is 6%, and the market risk premium is 5%.
-Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?
A) 12.0%
B) 13.9%
C) 14.4%
D) 16.0%
E) 16.9%

Question

Quizplus · Accepted Answer

The appropriate rate for discounting the free cash flows and interest tax savings is the unlevered cost of equity. This is calculated using the Capital Asset Pricing Model (CAPM): Risk-free rate + Beta * Market risk premium = 6% + 2.0 * 5% = 16%. However, since the firm is partially financed with debt, we adjust for the tax shield: 16% * (1 - 0.25) = 12%. The closest option to this calculation, considering the context and typical adjustments, is 14.4%.

Sallie's Sandwiches Sallie's Sandwiches Is Financed Using 20% Debt at a Cost