Question

GYPco Expects Ab Epit of $10000 every year forever. Gypco can borrow at 7 Persent . Suppose Gypco currently has no debt and its cost of equity 17 persent . The corporate tax rate is 35 persent . What will the value of the frim if Gypco borrow $15000 and uses the proceeds to purchase stock

Answer 1

Currently, the firm has no debt, so it is an unlevered firm and its cost of equity is the unlevered cost of equity.

Unlevered Value of firm = EBIT x (1 - tax rate) / Unlevered cost of equity = $10,000 x (1 - 0.35) / 17% = $38,235.294117647

Now, when the firm borrows debt, it will become a levered firm and so we need to calculate the value of levered firm.

As per MM proposition I with taxes -

Value of Levered firm = Value of unlevered firm + Value of tax shield on interest on debt

or, Value of levered firm = $38,235.294117647 + Debt x tax rate

or, Value of levered firm = $38,235.294117647 + ($15,000 x 35%) = $43,485.294117647 or $43,485.29