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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?

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Answer #1

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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