βu 2

Market premium 7%
risk-free rate 3%

Tax rate 40%

Required rate of return on assets (rU) 17.00%
Target debt in capital structure (D/V) 25%
Borrowing rate at target capital structure 5%
β at target capital structure 2.40 we assume β_D=0
Required rate of return on equity 19.8%
WACC at target 15.6%

β at target capital structure 2.34 You can calculate β_D using CAPM and use t
Required rate of return on equity 19.4%

1
D using CAPM and use the general form of the formula

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1. Valuation with all Equity Financing
0 1 2 3 4
Unlevered free cash flows (300) 40.0 40.8 41.6
NPVU (33.33)

3
2. Valuation at Target Capital Structure

0 1 2 3 4

Unlevered free cash flows (300) 40.0 40.8 41.6

NPVL (5.88)

4
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3. Initial high leverage

0 1 2 3

Unlevered free cash flows (300) 40.0 40.8 41.6

Levered terminal value (LTV) 306.00

Unlevered terminal value (UTV) 277.44
Dis. value of taxshields in TV (DVTS) 28.56

Debt outstanding at year end 150 150

Interest expense at 6% 9 9
Interest taxshield 3.6 3.6

PV of taxshields (years 1-2) 6.0% $6.60

PV of DVTS at market borrowing rate 6.0% 25.42
PV of UFCF (years 1-2) at rU 17.0% $63.99
PV of UTV at rU 17.0% 202.67
Total value $298.69
Less investment in PP&E & NWC (300.00)
NPVL (1.31)
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