Question

Suppose the corporate tax rate is 35 %. Consider a firm that earns $ 4 comma 000 in earnings before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 7 %.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity?

If the firm has no debt and pays out its net income as a dividend each year, the value of the firm's equity is $_____. (Round to the nearest dollar.)

b. Suppose instead the firm makes interest payments of $ 2, 700 per year. What is the value of equity? What is the value of debt?

The value of the firm with leverage is $______.

c. What is the difference between the total value of the firm with leverage and without leverage?

The difference between the total value of the firm with leverage and without leverage is $______.

d. To what percentage of the value of the debt is the difference in part (c) equal?

The percentage of the value of debt to the difference in (c) is ___%.

Answer #1

Solution;

a)Calculation of value of the firm's equity

Value of the firm's equity=Dividend/Risk free rate

=EBIT(1-tax rate)/7%

=$4000(1-0.35)/7%

**=$37,142.86**

b)Net Income=(EBIT-Interest)(1-tax rate)

=($4000-$2700)(1-0.35)

=$845

Value of equity=$845/7%=$12071.43

Value of debt=Interest/Risk free rate

=$2700/0.07=$38,571.43

c)Total value of firm with leverage=Value of debt+Value of equity

=$38,571.43+$12,071.43

=$50,642.86

Value of firm without leverage=value of equity=$37,142.86

Difference in value=$50,642.86-$37,142.86

**=$13,500**

**d)P**ercentage of the value of debt to the
difference in (c) is;

=(**$13,500/**$38,571.43)*40

=35%

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