Question

**Suppose the corporate tax rate is 35%. Consider a firm
that earns $3,000 before interest and taxes each year with no risk.
The firm's capital expenditures equal its depreciation expenses
each year, and it will have no changes to its net working capital.
The risk-free interest rate is**

**4%.**

**a. Suppose the firm has no debt and pays out its net
income as a dividend each year. What is the value of the firm's
equity?**

**b. Suppose instead the firm makes interest payments of
$1,000 per year. What is the value of equity? What is the value
of debt?**

**c. What is the difference between the total value of the
firm with leverage and without leverage?**

**d. The difference in (c) is equal to what percentage
of the value of the debt?**

**(Round to the nearest cent.)**

Answer #1

**Q.A)**

Net Income =(EBIT-Interest)*(1-TAx rate) = (3000-0)*(1-0.35)= 1950

They pay all thier earnigns as dividends so,Value of Equity= Dividend/ RIsk free rate = 1950/0.04

**Value of Equity= $ 48750**

**Q.B)**

Net income= (EBIT-Interest)*(1-Taxrate)= (3000-1000)*(1-0.35)= 1300

Value of Equity= Dividend/ RIsk free rate = 1300/0.04

**Value of Equity= $32500**

Value of Debt= Interest/Risk free rate =1000/0.04

**Value of Debt= $25000**

**Q.C)**

Levered firm means having debt and other is not

Value of firm with leverage = Value of debt + value of equity= 32500+25000

**Value of firm with leverage= $57500**

**Value of firm without leverage**= Value of only
equity = **$ 48750**

**Q.D)**

(Value of firm with leverage-Value of firm without leverage)/Value of Debt=[ (57500-48750)/25000]*100

**Difference %= 35%**

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