Question

Rappaport Industries has 5,650 perpetual bonds outstanding with a face value of $2,000 each. The bonds have a coupon rate of 6.4 percent and a yield to maturity of 6.7 percent. The tax rate is 35 percent. What is the present value of the interest tax shield?

Debbie's Cookies has a return on assets of 8.1 percent and a cost of equity of 12.5 percent. What is the pretax cost of debt if the debt–equity ratio is .87? Ignore taxes.

Stevenson's Bakery is an all-equity firm that has projected perpetual EBIT of $186,000 per year. The cost of equity is 13.3 percent and the tax rate is 34 percent. The firm can borrow perpetual debt at 6.2 percent. Currently, the firm is considering converting to a debt–equity ratio of .96. What is the firm's levered value?

Answer 1

1. Market Value of Debt =Number of Bonds* Par Value*interet Rate/YTM =5650*2000*6.7%/6.7% =10794029.8507
PV of tax shield =Debt*tax Rate =5650*2000*6.7%/6.7%*35% =3,955,000

2. Return on Assets=Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt
8.1% =1/1.87*12.5%+0.87/1.87*Cost of debt
Cost of Debt =(8.1%-12.5%/1.87)*1.87/0.87 =3.04%

3. Value of Unlevered Equity =EBIT*(1-Tax Rate)/Cost of Equity =186000*(1-34%)/13.3% =923007.5188

Debt value =0.96/1.96*923007.5188
Value of levered firm =Value of Unlevered Equity+Debt*Tax rate =923007.5188+0.96/1.96*923007.5188*34% =1076716.53