Question

Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with amarket price of $19 a share. The current cost of equity is 15.4%and the tax rate is 34%. The firm is considering adding $1.2 million of debt with a coupon rate of 8%to itscapital structure. The debt will be sold at par value. What is the levered value of the equity?

******Answer is $5,288,000 if you could explain why when computing you multiple the debt (1.2M) by the tax rate instead of the coupon rate that'd be great.

Answer 1

Given,

Shares outstanding = 320000 shares

Market price = $19

Tax rate = 34% or 0.34

Debt = $1.2 million or $1200000

Solution :-

Value of levered firm = (Shares outstanding x market price) + PV on interest tax shield (i.e., Debt x tax rate)

= (320000 shares x $19) + ($1200000 x 34%)

= $6080000 + $408000 = $6488000

Levered value of equity = value of levered firm - debt

= $6488000 - $1200000 = $5288000

Note:

PV of interest tax shield = (Debt x interest rate x tax rate)/interest rate = Debt x tax rate

That's why debt is multiplied by tax rate.