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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