Question

Answer the problem based on the framework of Modigliani and
Miller Propositions. Assume that a company has earnings before
interest and taxes (EBIT) of $1,000,000 every year forever. The
firm also has perpetual bonds with the market value of $2,000,000.
The before-tax cost of debt is 8 percent. The firm’s unlevered cost
of capital is 15 percent. The tax rate is 25 percent.

a) Find the value of the firm.

b) Find the value of equity.

c) Find the firm’s cost of equity.

d) Find the firm’s weighted average cost of capital.

Answer #1

a) | Value of Firm | = | [EBIT(1-t)]/ Ko | ||

= | [($ 1000000) x 0.75] / 15% | ||||

= | $ 50,00,000.00 | ||||

b) | Value of Equity | = | Value of firm - Value of Debt | ||

= | $ 5000000 - $ 2000000 | ||||

= | $ 30,00,000.00 | ||||

c) | Cost of Equity | = | Earning for ESH / Value of Equity | ||

= | $ 630000 / $ 3000000 | ||||

= | 21% |

d) Weighted Average Cost of Capital | = | WeKe + WdKd | ||||

= | 3/5 x 0.21 + 2/5 x 6% | |||||

= | 15% |

Workings:

W.N.1 | ||||

Income Statement | ||||

EBIT | $ 10,00,000.00 | |||

Less: | Interest | ($ 2000000 x 8%) | $ 1,60,000.00 | |

EBT | $ 8,40,000.00 | |||

Less: | Tax | ($ 840000 x 25%) | $ 2,10,000.00 | |

Earning for ESH | $ 6,30,000.00 |

W.N.2 | |||

Kd | = | Rate of Interest (1-t) | |

= | 8% (1-0.25) | ||

= | 6% |

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