Question

# An unlevered company with a cost of equity of 14% generates \$3 million in earnings before...

An unlevered company with a cost of equity of 14% generates \$3 million in earnings before interest and taxes (EBIT) each year. The decides to alter its capital structure to include debt by adding \$4 million in debt with a pre-tax cost of 7% to its capital structure and using the proceeds to reduce equity by a like amount as to keep total invested capital unchanged. The firm pays a tax rate of 39%.

Assuming that the company's EBIT stream can be earned into perpetuity and that the debt can be perpetually issued (or rolled), what is the value of the firm?

Value of Unlevered Firm = EBIT (1-taxes) / Ke

Ke = Unlevered Cost of Equity

= 3 (1-0.39) / 0.14

= 13.0714285714 mn

Value of Levered Firm =  Value of Unlevered Firm + taxes * Debt added

= 13.0714285714 mn + 0.39 * 4 mn

= 14.6314285714 mn

Value of Levered Firm will be \$14.6314285714 mn OR \$14.63 mn

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