Question

The market value of a firm with $650,000 of debt is $2,700,000. The pre-tax interest rate on debt is 12% per annum, and the company is in the 40% tax bracket.  The company expects $500,000 of earnings before interest and taxes every year in perpetuity.

Note: ignore costs of distress and bankruptcy.

      A.  What would the value of the firm be if it were financed entirely with equity?

      B.   What amount of the firm’s annual earnings is available to stockholders?

Answer 1

a. Market value of Firm = Value of Levered Firm = $2700000,

Debt of Firm = 650000, Tax rate = 40%

We need to Unlevered value of firm = Value of firm financed entirely with equity

We know that

Value of levered firm = Value of Unlevered Firm + Tax rate x Debt of firm

2700000 = Value of Unlevered Firm + 40% x 650000

2700000 = Value of Unlevered Firm + 260000

Value of Unlvered Firm = 2700000 - 260000 = 2440000

Hence value of firm financed entirely with equity = 2440000

b. Earnings before interest and tax =EBIT = 500000,

Interest on debt = Pre tax interest rate x Debt = 12% x 650000 = 78000

Earnings before tax = EBT = EBIT - Interest = 500000 - 78000 = 422000

Net income = EBT(1-tax rate) = 422000 (1-40%) = 422000 x 60% = 253200

Hence Earnings available to shareholders = Net income = $253200