Question

ABC Co. has $100,000 of Debt outstanding, and the corporate tax rate is 25 percent. Unlevered cost of capital was 12 percent, and cost of debt is 10%. Earnings before Interest and Taxes (EBIT) is $78,000. A) What is the present value of tax shield on debt? B) What is the value of the levered firm? C) What is the target debt-to-equity ratio if the targeted levered cost of equity is 13 percent?

Answer 1

Given:

• Value of Debt = $100,000
• Tax Rate = 25%
• Cost of Capital = 12%
• Cost of debt = 10%
• EBIT = $78,000

A) Value of tax shield on debt = ($100,000*10%) * 25% = $10,000 * 25% = $2,500

B) Value of the levered firm = EBIT / Cost of Capital = $78,000/12% = $650,000

C) Target debt-to-equity ratio if the targeted levered cost of equity is 13 percent

Cost of Capital = (Debt weight * Cost of Debt) + (Equity weight * Cost of Equity)

12% = (Dw * 10%) + (Ew * 13%)

As Dw + Ew = 1 ; Ew = 1 - Dw

12% = (Dw * 10%) + ((1-Dw) * 13%)

Solving the above, we get:

Dw = 0.33 ; Ew = 0.66

Hence, the target debt-to-equity ratio will be 1:2.