Question

The assumptions are: Return on assets 12% Cost of debt 10% Debt Value (perpetuity) 2000 Tax...

  1. The assumptions are:

Return on assets

12%

Cost of debt

10%

Debt Value (perpetuity)

2000

Tax rate

30%

Annual pre-tax earnings

600

  1. What would be the value of unlevered company?
  2. What would be the value of levered company?
  3. What is the cost of equity of levered company? (in %)
  4. What would be the value of the unlevered company if a growth rate of g=5% applies

Homework Answers

Answer #1
A] Value of unlevered firm [Vu] = 600*(1-30%)/12% = $                3,500
B] Value of levered firm [Vl] = Vu+B*t, where
B = Borrowings and t = tax rate
Vl = 3500+2000*30% = $                4,100
C] Cost of equity of the levered company = 12%+(12%-10%)*(1-30%)*2000/2100 = 13.33%
D] Value of unlevered firm [Vu] = 600*(1-30%)/(12%-5%) = $                6,000
Note:
Assumed that the annual pre-tax earnings is for the first year
Hence, the formula [Vu] = 600*(1-30%)/(12%-5%)
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