Question

Young Corporation has an expected EBIT of $19,750 every year forever. The company currently has no debt, and its cost of equity is 15 percent.

a) What is the current value of the company?

b) Suppose that the company can borrow at 10 percent. If the corporate tax rate is 35 percent what will the value of the firm be if the company takes on debt equal to 50 percent of its unlevered value?

c) Calculate the cost of equity, and WACC after the proposed recapitalization in question b.

Answer 1

a)

Since there is no debt we are finding the value of the unlevered firm (Vul)

Vul = EBIT / Cost of equity

= 19750 / 0.15

= 131667

b)

Value of the unlevered firm in presence of tax(Vul) = EBIT (1 - tax) / Cost of equity

=19750 * 0.65 / 0.15

=85583.33

Value of the firm = Vul + tax rate * D

=Vul + tax rate * (50% of Vul)

= 85583.33 + ( 0.35 * 0.5 * 85583.33 )

= 100560.4

c)

Re = Ro + (D/E) (Ro - Rd) ( 1 - tax)

where. Re = cost of levered equity

Ro = cost of levered equity = 0.15

D/E = debt equity ratio = 0.5

Rd = cost of debt borrowing

Hence,

Re = 0.15 + 0.5( 0.15 - 0.1) (1-.0.35)

= 0.15 + 0.5 * 0.05 * 0.65

= 0.16625 or 16.625%

WACC = weight of equity * Re + Weight of debt * Rd * (1-tax rate)

= 0.5 * 16.625 + 0.5 * 10* 0.65

= 11.5625%