Question

# Lone Star Industries expects to generate \$75,000 of earnings before interest and taxes (EBIT) in perpetuity....

Lone Star Industries expects to generate \$75,000 of earnings before interest and taxes (EBIT) in perpetuity. The company distributes all its earnings as dividends at the end of each year. The firm’s unlevered cost of capital is 18%, and the corporate tax rate is 40%.

a. What is the value of the company as an unlevered firm?

b. Suppose Lone Star just issued \$160,000 of perpetual debt with an interest rate of 10% and used the proceeds to repurchase stock. Use the APV approach to calculate the value of the company with leverage. Assume that the company will maintain a constant dollar level of debt.

Answer : (a.) Calculation of Value of Unlevered Firm

Value of Unlevered Firm =[ EBIT * ( 1 - Tax Rate)] / Unlevered Cost of Capital

= [ 75000 * ( 1 - 0.40) ] / 0.18

= \$250,000

(b.) Calculation of Value of  company with leverage. :

Value of Company = Value of Unlevered Firm + Net Present Value of Financing Effect

Value of Unlevered Firm = \$250000 (Already calculated in part a.)

Net Present Value of Financing Effect = 160,000 - {[160000 * 10% * (1 - 0.40) ] / 0.10}

= 160,000 - {9600 / 0.10}

= 160,000 - 96000

= 64,000

Value of Company = 250,000 + 64,000

= 314,000

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