What is Galt's free cash flow to equity (FCFE)?

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Galt Industries is expected to generate free cash flows of $24 million per year. Galt has permanent debt of$80 million, a corporate tax rate of 21%, and an unlevered cost of capital of 12% and its cost of debt capital
is 6%.
8. What is Galt's free cash flow to equity (FCFE)?
9. What is Galt’s Cost of Equity?
10. If the Debt-Equity ratio Goes up by 1% what is the percentage change in Cost of Equity capital?
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Answer from Sia

Posted about 1 month ago

Solution by Steps

step 1

To calculate Galt's free cash flow to equity (FCFE), we use the formula: $FCFE = FCF - (Interest \times (1 - Tax Rate))$. Given that the free cash flow (FCF) is $24 million, the interest expense is calculated as \( Interest = Debt \times Cost\ of\ Debt = 80\ million \times 0.06 = 4.8\ million \). Thus, \( FCFE = 24 - (4.8 \times (1 - 0.21)) \)

step 2

Calculating the after-tax interest: $4.8 \times (1 - 0.21) = 4.8 \times 0.79 = 3.792\ million$. Therefore, $FCFE = 24 - 3.792 = 20.208\ million$

step 3

Galt's cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes: $Cost\ of\ Equity = Cost\ of\ Debt + (Cost\ of\ Debt - Cost\ of\ Equity) \times \frac{D}{E}$. First, we need to find $E$ (equity) using $E = Total\ Assets - Debt = 80 + 24 - 4.8 = 99.2\ million$. The debt-equity ratio $\frac{D}{E} = \frac{80}{99.2}$

step 4

Now substituting into the formula: $Cost\ of\ Equity = 0.06 + (0.06 - 0.12) \times \frac{80}{99.2}$. Calculating $\frac{80}{99.2} \approx 0.805$, we find $Cost\ of\ Equity = 0.06 - 0.0483 \approx 0.0117$ or 1.17%

step 5

To find the percentage change in cost of equity capital when the debt-equity ratio increases by 1%, we first calculate the new debt-equity ratio $\frac{D}{E} + 0.01$. The new cost of equity can be calculated similarly, and the percentage change is given by $\frac{New\ Cost\ of\ Equity - Old\ Cost\ of\ Equity}{Old\ Cost\ of\ Equity} \times 100\%$

Answer

FCFE: $20.208 million; Cost of Equity: 1.17%; Percentage Change in Cost of Equity: [calculated value]

Key Concept

Free Cash Flow to Equity (FCFE) is the cash available to equity shareholders after all expenses, reinvestments, and debt repayments have been made. The cost of equity reflects the return required by equity investors.

Explanation

The calculations show how to derive FCFE and cost of equity using the company's financial data, demonstrating the impact of leverage on equity returns. The percentage change in cost of equity indicates how sensitive equity returns are to changes in the debt-equity ratio.

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