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Question 2: (25 marks) Eclipse Corporation uses no debt. The weighted average cost of capital is...

Question 2:

Eclipse Corporation uses no debt. The weighted average cost of capital is 8%.

Required

1. If the current market value of the equity is $18 million and there are no taxes, what is EBIT?

2. Suppose the corporate tax rate is 35%. What is EBIT in this case? What is the WACC? Explain.
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Answer #1

Solution

Eclipse Corp

1. Computation of EBIT assuming current market value of equity as $18 million, cost of capital:

Value of firm with no debt (unlevered) = EBIT/WACC

EBIT = earnings before interest and taxes

WACC = weighted average cost of capital = 8%

Value of firm = $18,000,000

Substituting the values,

$18,000,000 = EBIT/8%

Hence, EBIT = 18,000,000 x 8% = $1,440,000

2. Computation of EBIT assuming corporate tax rate as 35%:

As per Modigliani-Miller approach, V = VU + TCD

V = $18,000,000

WACC = 8%

D = 0

V = 18,000,000 = (1- 0.35) EBIT/0.08 + 0

18,000,000 = (0.65 x EBIT)/0.08

18,000,000 x 0.08 = 0.65 EBIT

EBIT = 1,440,000/0.65 = $2,215,385

Hence, EBIT = $2,215,385

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