Question

Enoch-Arden Corporation has earnings before interest and taxes of $3 million and a 40 percent tax rate. It is able to borrow at an interest rate of 14 percent, whereas its equity capitalization rate in the absence of borrowing is 18 percent. The earnings of the company are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. In the presence of corporate but no personal taxes, what is the value of the company in an M&M world with no financial leverage? With $4 million in debt? With $7 million in debt?

Answer 1

Solution:

Value of firm if unlevered:

EBIT	3000000	Given
Interest	0	Given
EBT	3000000	=EBIT-Interest
Tax	1200000	=EBT*Tax Rate
EAT	1800000	=EBT-Tax
Equity Capitalization Rate (Ke)	0.18	Given
Value of the firm	$10,000,000	=EAT/Ke

Value with $4 million debt:

Value of unlevered firm + PV of tax-shield benefits of debt

$10,000,000 + $4,000,000(0.4)

$11,600,000

Value with $7 million debt:

Value of unlevered firm + PV of tax-shield benefits of debt

$10,000,000 + $7,000,000(0.4)

$12,800,000