based upon part a would you recommend that skates use its excess debt capacity 546371

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 they have provided you with the following information.

• Over the last 10 years, reinvestments (net capital expenditures + working capital investments) have 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. Estimate the value of financial flexibility as a percent of firm value, on an annual basis.

b. Based upon part a, would you recommend that Skates use its excess debt capacity?