Question

Company U has no debt outstanding currently and the cost of equity is 12%. Its EBIT is expected to be $ 201896 every year forever. The tax rate is 35%. Calculate the value of the firm. Company U has no debt outstanding currently and the cost of equity is 12%. Its EBIT is expected to be $ 201896 every year forever. The tax rate is 35%.Calculate the value of the firm if it borrows $ 453493 and uses the proceeds to repurchase the shares. Company U can borrow at 6% (cost of debt). Company U has no debt outstanding currently and the cost of equity is 12%. Its EBIT is expected to be $ 201896 every year forever. The tax rate is 35%. Firm borrows $ 453493 and uses the proceeds to repurchase the shares. Company U can borrow at 6% (cost of debt). What is the debt to equity ratio of the company after the change in the capital structure? Express you answer as %.

Answer #1

1) Where there is no debt

Value of Company U = EBIT(1-tax rate) / Cost of equity

= 201896(1-35%) / 12%

= 201896(1-0.35) / 0.12

= 201896(0.65) / 0.12

=131232/0.12

=10,93,603 $

2) Where comapny borrows $ 453493 and uses the proceeds to repurchase the shares

Value of company U = Value of unlevered firm + (Debt x tax rate)

= 1093603 + (453493 x 35%)

= 1093603 + 158723

= 1252326 $

3) here value of equity = value of company - value of debt

= 1252326 - 158723

= 1093603 $

Thus debt to equity ratio = Debt/equity

= 158723/1093603

=0.1451

i.e 14.51%

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