Question

Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corporation is an unlevered firm, and R Inc. is a levered firm with debt of $3.5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $1.5 million and a marginal corporate tax rate of 35%. Q Corporation has a cost of capital of 15%.                                       

a.   What is Q Corporation’s firm value?                    

b.   What is R Inc.’s firm value?                                 

c.   What is R Inc.’s equity value?

d.   What is Q Corporation’s cost of equity capital?   

e.   What is R Inc.’s cost of equity capital?

Answer 1

a. Q corporation'f firm value =EBIT*(1-Tax rate)/Cost of Capital =1.5*(1-35%)/15% =6.5 million or 6500000

b. Value of R Inc's =Value of Unleverd firm+Debt*Tax Rate =6500000+3500000*35% =7725000

c. R inc's equity value =Value of R Inc's-Debt value =7725000-3500000=4225000

d. Q Corporation cost of equity capital =15%

3. Cost of equity capital of R =Cost of equity unleverd+(Cost of equity Unleverd-Cost of debt)*Debt/Equity*(1-tax Rate)
=15%+(15%-10%)*3500000/4225000*(1-35%)=17.69%