Question

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

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%)