Question

Suppose a firm financed with a $150 million perpetual debt, and with 10 million shares each worth $15. The expected return on the debt is 8% and the expected return on equity is 16%. The tax rate is 40%. What is the value of the firm and the pretax earnings of the company?

Answer 1

Debt in the capital structure = $ 150 M

Equity in the capital structure = 10 M shares * $ 15 per share = $ 150 M

So D/E = 1

D/V, Wd = 0.5 and E/V, We= 0.5

Value of the firm, V = Value of Debt + Value of Equity= 150 + 150 = $ 300 M

Cost of debt, kd = 8%

Cost of Equity, ke = 16% , Tax rate , t = 40%

Weighted average cost of Capital (WACC) = kd * Wd*(1-t) + Ke * We = 8% * 0.5*(1-40%) + 16% * 0.5

= 10.4%

Value of the firm = NOPAT / WACC = EBIT *(1-t) / WACC

300 = EBIT *(1-40%) / 10.4%

(300* 10.4%)/ 0.6 = EBIT = $ 52 M

Pre-tax earnings = EBIT = $ 52 M