You are analyzing Skates Inc., a firm that manufactures skateboards. The firm is currently unlevered and has a cost of equity of 12%. You estimate that Skates would have a cost of capital of 11% at its optimal debt ratio of 40%. The management, however, insists that it will not borrow the money because of the value of maintaining financial flexibility and has provided you with the following information:
Over the past 10 years, reinvestment (net capital expenditures + working capital investments) has amounted to 10% of firm value, on an annual basis. The standard deviation in this reinvestment has been 0.30. The firm has traditionally used only internal funding (net income + depreciation) to meet these needs, and these have amounted to 6% of firm value.In the most recent year, the firm earned $180 million in net income on a book value of equity of $1 billion, and it expects to earn these excess returns on new investments in the future. The riskless rate is 5%.
a. Calculate the alternative estimating esteem (and show the formula)
b. Estimate the value of financial flexibility as a percent of firm value on an annual basis.
c. Based on (b), would you recommend that Skates use its excess debt capacity?