Valuing a Leveraged Buyout Candidate

Valuing a Leveraged Buyout Candidate.  

May Department Stores Company (May) operates retail department store chains throughout the United States. Assume that at the end of Year 2, May's balance sheet reports debt of $4,658 million and common shareholders" equity at book value of $3,923 million. The market value of its common stock is $6,705, and its market equity beta is 0.88.

Suppose an equity buyout group is considering an LBO of May as of the beginning of Year 3. The group intends to finance the buyout with 25% common equity and 75% debt carrying an interest rate of 10%. Assume the group projects that the free cash flows to all debt and equity capital stakeholders of May will be as follows: Year 3,$798 million; Year 4,$861 million; Year 5 $904 million; Year 6, $850 million; Year 7, $834 million; Year 8, $884 million; Year 9,$919 million; Year 10,$947 million; Year 11,$985 million; and Year 12,$1,034 million. The group projects free cash flows to grow 3% annually after Year 12.

This problem sets forth the steps you might follow in deciding whether to acquire May and the value to place on the firm.

REQUIRED;

 Compute the cost of equity capital with the new capital structure that results from the LBO. Assume a risk-free rate of 4.2% and a market risk premium of 5.0%