Fill This Form To Receive Instant Help
Fill This Form To Receive Instant Help
Homework answers / question archive / A firm can get $1,000,000 in exchange of 25% of its equity
A firm can get $1,000,000 in exchange of 25% of its equity. After investing the amount raised in the firm, the firm expects to generate $300,000 in FCF next year which is expected to grow at 3% in perpetuity after that.
a)Calculate the cost of capital to the firm.
b)How does this cost relate to the WACC of the firm? (Assume that the firm has no debt and that its debt capacity is zero.)
Before closing the deal, Mr. Wonderful approaches the firm and argues that he is willing to provide the $1,000,000 but since he is "smart capital" he requests 40% of the equity of the firm.
c)Calculate the cost of Mr. Wonderful capital for the firm if he does not intervene in the firm's operations (i.e., assuming that the firm's cash flows are as described above). How is this cost of capital related to the WACC of the firm?
d)Suppose now that Mr. Wonderful affects the firm's cash flows, i.e., he can accelerate firm's growth to 5% for the first 5 years. After that, the firm's cash flow will grow at 3% in perpetuity. Calculate the cost of Mr. Wonderful capital to the firm. How does this cost relate to the WACC of the firm?
e)Is Mr. Wonderful a desirable source of funds for the owners of the firm?
f) Suppose that Mr. Wonderful is able to make the firm grow at k% rather than 3% for the first five years. Find the rate of growth that would leave the firm indifferent between bringing Mr. Wonderful as a source ofcapital to the firm.
Answer:
a) Calculate the cost of capital to the firm
Cost of Capital = [(25%*300,000)/1,000,000]*(1+3%)
= 7.725%
b) How does this cost relate to the WACC of the firm? (Assume that the firm has no debt and that its debt capacity is zero.)
Assuming 100% equity financing, the cost of equity would be equal to the company's WACC, hence, WACC would be equal to 7.725%
c)Calculate the cost of Mr. Wonderful capital for the firm if he does not intervene in the firm's operations (i.e., assuming that the firm's cash flows are as described above). How is this cost of capital related to the WACC of the firm?
Cost of Capital = (40%*300,000)/1,000,000]*(1+3%)
= 12.36%
Since the firm would be 100% equity financed, the cost of equity would be equal to firm's WACC hence equal to 12.36%.
d)Suppose now that Mr. Wonderful affects the firm's cash flows, i.e., he can accelerate firm's growth to 5% for the first 5 years. After that, the firm's cash flow will grow at 3% in perpetuity. Calculate the cost of Mr. Wonderful capital to the firm. How does this cost relate to the WACC of the firm?
Future Value of Equity after 5 year firm growth would be
PV = 1,000,000*(1+5%)^5
= $1,276,281.56
Considering a 5% cash flow growth in the next five years, revenues in the 5th year would be
CF5 = 300,000*(1.05)^4
= $364,651.88
Cost of Capital = [(40%*364,651.88)/1,276,281.56] *(1+3%)
= 11.77%
e) Is Mr. Wonderful a desirable source of funds for the owners of the firm?
No. The cost of capital that the firm would incur in Mr. Wonderful's deal would be higher compared to the previous offer of $1,000,000 for 25% equity.
f) Suppose that Mr. Wonderful is able to make the firm grow at k% rather than 3% for the first five years. Find the rate of growth that would leave the firm indifferent between bringing Mr. Wonderful as a source of capital to the firm.
The cost of capital should be equal to 7.725% to be indifferent bewtween bringing Mr. Wonderful as a source of capital.
7.725% = [(40%*300,000*(1+k)^4/1,000,000*(1+k)^5] *(1+3%)
0.075 = [(40%*300,000*(1+k)^4/1,000,000*(1+k)^5]
0.075 = 0.12*(1+K)^4/*(1+K)^5
K = 60%
The firm should grow at 60% to be indifferent between bringing MR wonderful as the source of capital and taking the previous deal.
