An analyst has prepared the following scenarios for Schneider, Inc.:
Scenario 1 Assumptions:
- Tax rate is 40%.
- Weighted average cost of capital (WACC) = 12%.
- Constant growth rate in free cash flow = 3%.
- Last year, free cash flow to the firm (FCFF) = $30.
- Target debt ratio = 10%.
Scenario 2 Assumptions:
- Tax rate is 40%.
- Expenses before interest and taxes (EBIT), capital expenditures, and depreciation will grow at 15% for the next three years.
- After three years, the growth in EBIT will be 2%, and capital expenditure and depreciation will offset each other.
- WACC during high growth stage = 20%.
- WACC during stable growth stage = 12%.
- Target debt ratio = 10%.
|
Scenario 2 FCFF |
Year 0
(last year) |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
| EBIT |
$15.00 |
$17.25 |
$19.84 |
$22.81 |
$23.27 |
| Capital Expenditures |
6.00 |
6.90 |
7.94 |
9.13 |
|
| Depreciation |
4.00 |
4.60 |
5.29 |
6.08 |
|
| Change in Working Capital |
2.00 |
2.10 |
2.20 |
2.40 |
2.40 |
| FCFF |
|
5.95 |
7.06 |
8.25 |
11.56 |
Assuming that Schneider, Inc., slightly increases its financial leverage, what should happen to its firm value? The firm value should:
A. not change because financial leverage has no relationship with firm value.
B. increase due to the additional value of interest tax shields.
C. decline due to the increase in risk.
|
