Question

Bruin Industries just issued $275,000 of perpetual 6 percent debt and used the proceeds to repurchase stock. The company expects to generate $126,000 of earnings before interest and taxes in perpetuity. The company distributes all its earnings as dividends at the end of each year. The firm’s unlevered cost of capital is 12 percent, and the corporate tax rate is 34 percent.

A. What is the value of the company as an unlevered firm? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

B. Use the adjusted present value method to calculate the value of the company with leverage. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

C. What is the required return on the firm’s levered equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

D. Use the flow to equity method to calculate the value of the company’s equity. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

A). V_U = EBIT(1 - T_C) / Cost of Capital

= $126,000(1 - 0.34) / 0.12

= $83,160 / 0.12 = $693,000

B). APV = NPV_U + NPV_F

= V_U + T_CB = $693,000 + [0.34 x $275,000] = $693,000 + $93,500 = $786,500

The value of the firm’s equity is thus:

$786,500 - B= $786,500 - $275,000 = $511,500

C). By MM Prop II (with taxes),

r_s = r_u + [(B/S)(1 - T_c)(r_u - R_B)]

= 0.12 + [($275,000/$511,500)(1 - 0.34)(0.12 - 0.06)]

= 0.12 + [0.5376 x 0.66 x 0.06] = 0.12 + 0.0213 = 0.1413, or 14.13%

D). V_e = CF_levered / r_s

= [{EBIT - (K_d x V_d)}(1 - T_c)] / r_s

= [{$126,000 - (0.06 x $275,000)}(1 - 0.34)] / 0.1413

= $72,270 / 0.1413 = $511,500