Question

Hanover Industries has expected earnings before interest and taxes of $630,300, an unlevered cost of equity of 14.7 percent, and a combined tax rate of 23 percent. The company also has 11,000senior bonds outstanding that carry a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company? What is the target capital structure of the firm if the levered cost of equity is 17.25? Assume MM with taxes holds.

Answer 1

Cost of Equity levered = 17.25%
Unlevered Cost of Equity = 14.7%
Cost of Debt = Coupon rate = 7%
Value of Equity = EBIT*(1-Tax Rate)/Unlevered Cost of Equity = 630,300*(1-23%)/14.7% = 3301571.43
Value of company = Value of Unlevered firm + Debt * tax rate = 3301571.43+11000*1000*23% = 5,831,571.43

Cost of Levered Equity = Cost of Unlevered Equity +(Cost of Unlevered Equity- Cost of Debt)* Debt*(1-Tax Rate)/ Equity
14.7% + (14.7%-12%)(1-30%)*D/E = 17.25%
0.0189 D/E = 17.25%-14.7%
Target D/E = 0.0255/0.0189 = 1.35

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