Question

An unlevered company with a cost of equity of 12% expects to generate $6 million in...

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?

Homework Answers

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
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