Question

12. Old School Corporation expects an EBIT of $23,750 every year forever. Old School currently has no debt, and its cost of equity is 15 percent. The firm can borrow at 9 percent. If the corporate tax rate is 35 percent. (Do not round intermediate calculations. Round the final answers to 2 decimal places. Omit $ sign in your response.) a. What is the value of the firm? b-1. What will the value be if Old School converts to 60 percent debt? b-2. What will the value be if Old School converts to 99 percent debt?

Answer 1

a)The value of the firm(unlevered) is computed as shown below:

[ EBIT ( 1 - tax rate ) ] / cost of equity

= [ 23750( 1 - 0.35 ) ] / 0.15

= 102916.67

b-1) If the firm converts to 60% of debt, the value of the firm (levered) is computed as shown below:

value of levered firm = value of unlevered firm + value of debt * tax rate

= 102916.67+102916.67x 0.60 x 0.35

=124529.17

b-2) ) If the firm converts to 99% of debt, the value of the firm (levered) is computed as shown below:

value of levered firm = value of unlevered firm + value of debt * tax rate

= 102916.67+102916.67x 0.99*0.35

=138577.30

Note:

A company that has no debt is called an unlevered firm.

A company that has debt in its capital structure is a levered firm.