Assignment Question 1
SOLUTION:
a)
Unlevered free cash flow of Samba Shoe Division (in $millions):
Revenue:
Variable Cost:
Annual Depreciation
Taxable Income
Taxes (@40%)
Income after tax
Depreciation
Investment
Cash Flow
$10.0
(5.5)
(1.0)
$ 3.5
(1.4)
$2.1
1.0
(1.0) ( re investment)
$2.1 million
Unlevered worth of Samba= $2.1 million / 0.16 = $13.125 million.
b) If Samba had $5 million of debt;
Market Value with Debt = Market Value without Debt + PV of Interest Tax Shield
VL = VU + T x B
= $13.125 + (.4 x 5) = $15.125 million
Samba Equity = $15.125  $5 = $10.125 million
c) Samba’s cost of equity;
ke = k + (1-T)*(k - r)D/E
= .16 + (1-.4)*(.16-.10)*5/10.125
= .1778
So, 0.1778 rate of return is required is for Samba’s shareholders.