Use the information for the question(s)below.
Luther Industries has no debt and expects to generate free cash flows of $48 million each year.Luther believes that if it permanently increases its level of debt to $100 million,the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers.As a result,Luther's expected free cash flows with debt will be only $44 million per year.Suppose Luther's tax rate is 21%,the risk-free rate is 6%,the expected return of the market is 14%,and the beta of Luther's free cash flows is 1.25 (with or without leverage).
-The value of Luther without leverage is closest to:

Question

Quizplus · Accepted Answer

Without leverage, the value of Luther can be calculated using the free cash flow (FCF) model:

FCF1 / (r - g)

Where FCF1 is the expected free cash flow for the next year, r is the discount rate, and g is the expected growth rate of FCF. Since Luther has no growth, g = 0.

FCF1 = $48 million 
r = 6% (since the risk-free rate is given)

To calculate the beta of the unlevered firm, we use the Hamada equation:

Beta_L = Beta_U [1 + (1 - t) (D/E)]

Where Beta_U is the beta of the unlevered firm, t is the tax rate, and D/E is the debt-to-equity ratio. Since Luther has no debt, D/E = 0.

Beta_L = 1.25 [1 + (1 - 0.21) (0)] = 1.25

Using the CAPM, the required return on equity for Luther without leverage is:

r = Rf + Beta_L (Rm - Rf)

= 6% + 1.25(14% - 6%)

= 16%

Therefore, the value of Luther without leverage is:

$48 million / (0.16 - 0) = $300 million

Use the Information for the Question(s)below