Question

Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.18. Its current stock price is $49 per share, with 2.4 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.45 and can borrow at 4.0%, just 20 basis points over the risk-free rate of 3.8%. The expected return of the market is 10.3%, and PKGR's tax rate is 25%

a. This year, PKGR is expected to have free cash flows of $6.3 billion. What constant expected growth rate of free cash flow is consistent with its current stock price?
b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.45, it believes its borrowing costs will rise only slightly to 4.3%. If PKGR announces that it will raise its debt-equity ratio to 0.45 through a leveraged recap, determine the increase or decrease in the stock price that would result from the anticipated tax savings.

Answer 1

The student is asking about the computation of the growth rate of free cash flow consistent with the current stock price and the effect of a higher debt-equity ratio on the stock price considering tax savings. These require understanding the Gordon Growth Model and tax shield benefits for valuing stocks and considering capital structure decisions, suitable for Business or Finance students at the college level.

Step-by-step explanation:

The student's question involves calculating the consistent expected growth rate of free cash flow that justifies the current stock price, and also determining the impact of a change in the debt-equity ratio on the stock price due to tax savings following a leveraged recap. Calculating the expected growth rate would require the use of the Gordon Growth Model which considers the current stock price, dividend payouts, and the expected return (cost of equity). To address the second part of the question, one would need to calculate the tax shield benefit of the additional debt and how this affects the firm's value and hence the stock price.

These types of financial calculations involve understanding the concepts of present value, the impact of financial leverage, and the principles of corporate finance. This question is set in a realistic financial context where Prokter and Gramble (PKGR) is considering changing its capital structure to include more debt, potentially affecting the firm's risk, cost of capital, and shareholder value. The question assumes a significant level of financial knowledge, indicative of a higher education setting typically found in Business studies or a related field such as Finance or Accounting.