The following information has been presented to you about the Gibson Corporation.
$\begin{array}{l}
\begin{array} { l }
\text { Total assets } & \$ 3,000 \text { million Tax rate } \
\text { Operating income (EBIT) } & \$ 800 \text { million Debt ratio } \
\text { Interest expense } & \$ 0 \text { million WACC } \
\text { Net income } & \$ 480 \text { million M/B ratio } \
\text { Share price } & \$ 32.00 \mathrm{EPS}=\mathrm{DPS}
\end{array}
\begin{array} { l }
40 \% \
0 \% \
10 \% \
1.00 x\
\$ 3.20
\end{array}
\end{array}$

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm?
A) $3,200
B) $3,600
C) $4,000
D) $4,200
E) $4,800

Question

The following information has been presented to you about the Gibson Corporation. 
$\begin{array}{l}
\begin{array} { l } 
\text { Total assets } & \$ 3,000 \text { million Tax rate } \
\text { Operating income (EBIT) } & \$ 800 \text { million Debt ratio } \
\text { Interest expense } & \$ 0 \text { million WACC } \
\text { Net income } & \$ 480 \text { million M/B ratio } \
\text { Share price } & \$ 32.00 \mathrm{EPS}=\mathrm{DPS}
\end{array}
\begin{array} { l } 
40 \% \
0 \% \
10 \% \
1.00 x\
\$ 3.20
\end{array}
\end{array}$

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm?
A) $3,200
B) $3,600
C) $4,000
D) $4,200
E) $4,800

Quizplus · Accepted Answer

Step 1: Find the new WACC:
$\mathrm{WACC}=\mathrm{w}_{\mathrm{d}^{\mathrm{r}} \mathrm{S}}+\mathrm{w}_{\mathrm{d}}(1-\mathrm{T}) \mathrm{r}_{\mathrm{d}}=(0.8(0.11))+(0.2(1-0.4) 0.10)=0.10$
Step 2: Find the free cash flow: Because there is no growth, there is no investment in capital, hence FCF is equal to NOPAT:
$ \mathrm{FCF}= $ NOPAT $ - $ Investment in capital $ =\mathrm{EBIT}(1-\mathrm{T})-0=\$ 800(1-0.4)= $ $ \$ 480 $ million.
Step 3: Find the new value of the firm:
$\mathrm{V}=\mathrm{FCF} /(\mathrm{WACC}-\mathrm{g})=\$ 480 / 0.10=\$ 4,800 \text { million. }$

The Following Information Has Been Presented to You About the Gibson