Question

This question has 4 little questions.

Tim Hortons currently has EBIT of $43,000 and is all equity financed. EBIT are expected to grow at a rate of 1% per year. The firm pays corporate taxes equal to 29% of taxable income. The cost of equity for this firm is 16%.

1. What is the value of the firm when it is equally financed? (answer: $203,533.33)

2. When the firm issues $55,000 of debt paying interest of 8% per year and uses the proceeds to retire equity. The debt is expected to be permanent.

  The value of the firm is? (answer:  219483.33)

The value of the equity after the debt issue is? (answer: 164483.33)

3. Suppose that with the $55,000 of debt the firm has a value of $219,483.33 and a value of equity of $164,483.33. What will be the expected rate of return on the equity? (Answer is 17.9)

Please show steps! Excel is fine too please show formulas!

Answer 1

1]	Value of the Unlevered firm [Vu] = EBIT*(1-t)/(rsu-g) = 43000*(1-29%)/(0.16-0.01) =	$      203,533.33
	[rsu = cost of unlevered equity]
2]	Value of the levered firm = Vl+B*t = 203533.33+55000*29% =	$      219,483.33
	[B=Borrowings]
	Value of the equity after the debt issue = Vl-B = 219483.33-55000 =	$      164,483.33
3]	Expected rate of return on the equity [levered] [rsl] = rsu+(rsu-rd)*(1-t)*D/E = 16%+(16%-8%)*(1-29%)*55000/164483.33 =	17.9%
	[rd = Cost of debt]