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%