Question

Company ChatV3 is expected to earn 1350 and 1630 before interest and taxes in year 2023 and 2024. The market expects these earnings to grow at a rate of 3.1% per year after 2024. The firm will make no net investments in long-term capital (i.e., capital expenditures equal depreciation of long-term assets) nor changes to net working capital. It has debt of 4250 at the end of 2022 with pre-tax cost of debt of 5.2%. The debt for 2023 and 2024 is expected to be 4500 and 4639.5 respectively. It then grows by 3.1% to keep a constant ratio of debt to equity every year. Assume that the corporate tax rate equals 22%. Suppose the risk-free rate equals 4%, and the expected return on the market equals 9%. Assume the firm's asset beta equals its industry beta, which is 1.35.

REQUIRED:

a. Estimate the firm level free cash flows at the end of 2023-2025 and the unlevered cost of equity capital.

(12 marks)

b. If ChatV3 were an all-equity (unlevered) firm, estimate its market value at the end of 2023 and 2024.

(10 marks)

c. Assuming the debt is fairly priced and the future interest payments have the same beta as Chatv3 assets, calculate the present value of Chatv3's interest tax shield at the end of 2023 and 2024.

(20 marks)

d. Estimate the market value of the firm and its equity at the end of 2023 (10 marks)

e. Calculate the implied WACC and cost of equity in 2023.

(20 marks)

(f) Assuming that the proceeds from any increases in debt are paid out to equity holders, estimate cash flows that the equity holders (FCFE) expect to receive in 2023 and 2024

(20 marks)

g. Explain the difference between the WACC and the cost of unleveraged capital.

(8 marks)

[Total 100 marks]