Question

An unlevered company with a cost of equity of 12% expects to generate $6 million in earnings before interest and taxes (EBIT) each year into perpetuity. The firm pays a tax rate of 26%.

Based on its after-tax earnings and cost of equity, what is the value of the firm?

An unlevered company with a cost of equity of 16% generates $5 million in earnings before interest and taxes (EBIT) each year. The decides to alter its capital structure to include debt by adding $3 million in debt with a pre-tax cost of 8% to its capital structure and using the proceeds to reduce equity by a like amount as to keep total invested capital unchanged. The firm pays a tax rate of 28%.

Assuming that the company's EBIT stream can be earned into perpetuity and that the debt can be perpetually issued (or rolled), what is the value of the firm?

Answer 1

1]	Value of firm [unlevered] = EBIT*(1-t)/rsu, where
	rsu = cost of unlevered equity,
	Therefore, value of the unlevered firm = 6000000*(1-26%)/12% =	$      37,000,000
2]	Value of the unlevered firm = EBIT*(1-t)/rsu = 5000000*(1-28%)/16% =	$      22,500,000
	Value of the levered firm = Value of the unlevered firm+Borrowings*tax rate = 22500000+3000000*28% =	$      23,340,000