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?

 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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