Question 16

Mojito Mint Company has a debt-to-equity ratio of 2/3. The required return on the firms
unlevered equity is 16%, and the pre-tax cost of the firms debt is 10%. Sales revenue for
Mojito is expected to remain stable indefinitely at last years level of $19,740,000. Variable costs
amount to 60% of sales. Mojito is taxed at the corporate tax rate of 40%. The firm distributes
all of its earnings as dividends at the end of each year.

a. If Mojito were financed entirely by equity, how much would it be worth?

b. What is the required return on the firms levered equity (r S)?
c. Use the Weighted Average Cost of Capital method to calculate the value of Mojito
Mint. What is the value of the firms equity? What is the value of the firms debt?
d. Use the Flow-to-Equity method to calculate the value of Mojito Mints equity.

a) If Mojito were financed entirely by equity, the value of the firm would be equal to the present
value of its unlevered after-tax earnings, discounted at its unlevered cost of capital of 16%.

Mojito Mint Company

Sales Revenue $19,740,000
Variable Costs 11,844,000
EBIT 7,896,000
Taxes at 40% 3,158,400
Unlevered After-Tax Earnings 4,737,600

VU = $4,737,600 / 0.16

= $29,610,000

Therefore, Mojito Mint Company would be worth $29,610,000 as an unlevered

firm.

b) According to Modigliani-Miller Proposition II with corporate taxes:

rS = r0 + (B/S)(r0 rB)(1 TC)

where r0 = the required return on the equity of an unlevered firm

rS = the required return on the equity of a levered firm

rB = the pre-tax cost of debt

TC = the corporate tax rate

B/S = the firms debt-to-equity ratio

 In this problem:

r0 = 0.16

rB = 0.10

TC = 0.40

B/S = 2/3

The required return on Mojitos levered equity is:

rS = r0 + (B/S)(r0 rB)(1 TC)

= 0.16 + (2/3)(0.16 0.10)(1 0.40)

= 0.184

The required return on Mojitos levered equity (rS) is 18.4%.

c) In a world with corporate taxes, a firms weighted average cost of capital (r wacc)
equals:

rwacc = {B / (B+S)}(1 TC) rB + {S / (B+S)}rS

where B / (B+S) = the firms debt-to-value ratio

S / (B+S) = the firms equity-to-value ratio

rB = the pre-tax cost of debt

rS = the cost of equity

TC = the corporate tax rate

The problem does not provide either Mojitos debt-to-value ratio or Mojitos equity-
to-value ratio. However, the firms debt-to-equity ratio of 2/3 is given, which can be
written algebraically as:

B / S = 2/3

Solving for B:
B = (2/3)(S)

A firms debt-to-value ratio is: B / (B+S)

Since B = (2/3)(S):

Mojitos debt-to-value ratio = (2/3)(S) / { (2/3)(S) + S}

= (2/3)(S) / (5/3)(S)

= (2/3)/(5/3)

= 2/5

Mojitos debt-to-value ratio is 2/5.

A firms equity-to-value ratio is: S / (B+S)

Since B = (2/3)(S):

Mojitos equity-to-value ratio = S / {(2/3)(S) + S}

= S / (5/3)(S)

= (1 / (5/3))

= 3/5
Mojitos equity-to-value ratio is 3/5.

The inputs to the WACC calculation are:

B / (B+S) = 2/5

S / (B+S) = 3/5

rB = 0.10

rS = 0.184

TC = 0.40

rwacc = {B / (B+S)}(1 TC) rB + {S / (B+S)}rS

= (2/5)(1 0.40)(0.10) + (3/5)(0.184)

= 0.1344

Mojitos weighted average cost of capital is 13.44%.

Use the weighted average cost of capital to discount the firms unlevered after-tax
earnings.

VL = $4,737,600 / 0.1344

= $35,250,000

Therefore, the value of Mojito Mint Company is $35,250,000.

Since the firms equity-to-value ratio is 3/5, the value of Mojitos equity is
$21,150,000

{= (3/5)($35,250,000)}.

Since the firms debt-to-value ratio is 2/5, the value of Mojitos debt is $14,100,000

{= (2/5)( $35,250,000)}.
d) In order to value a firms equity using the Flow-to-Equity approach, discount the cash
flows available to equity holders at the cost of the firms levered equity (r S).

Since the pre-tax cost of the firms debt is 10%, and the firm has $14,100,000 of debt
outstanding, Mojito must pay $1,410,000 (= 0.10 * $14,100,000) in interest at the end
of each year.

Mojito Mint Company

Sales Revenue 19,740,000
Variable Costs 11,844,000
EBIT 7,896,000
Interest 1,410,000
Pre-Tax Earnings 6,486,000
Taxes at 40% 2,594,400
After-Tax Earnings 3,891,600

Since the firm pays all of its after-tax earnings out as dividends at the end of each
year, equity holders will receive $3,891,600 of cash flow per year in perpetuity.

S = Cash Flows Available to Equity Holders / rS

= $3,891,600 / 0.184

= $21,150,000

The value of Mojitos equity is $21,150,000.