Question

Question 3:

Pinnacle Corporation expects an EBIT of $19,750 every year in perpetuity. Currently the company has no debt on their books and its cost of equity is 15%. Pinnacle can borrow at a rate of 10%. If the corporate tax rate is 35%, what is the value of the firm? What will the value be if the company converts to 50% debt? To 100% debt?

Answer 1

With no debt, we are basically finding the value of the unlevered firm.

V-UL= EBIT(1-t) /kul= $ 19750(0.65)/0.15= $ 12837.5/0.15= $ 85583.34

With debt we simply need to use the equation for the value of a levered firm.With 50% debt half of the firm's value tied up in debt, so value of firm is as follows,

V= V-UL+Tax rate*B(Debt) = 85583.34+0.35*(85583.34/2)

=85583.34+14977.08= $ 100560.42

With 100% debt, the value of firm is:

V= $ 85583.34+0.35($ 85583.34) = (1.35)($ 85583.34) =$ 115537.509