Question

The current market value of the all equity firm Hugh Sweets Shops is $21.5 million.

        a. If there are no taxes and the EBIT is $2,633,750, what is the cost of equity? What is the WACC?

        b. If the tax rate is 40%, what is the EBIT if the unlevered cost of equity is 12.25%? What is the WACC?

(Assume there is no cost of financial distress and general M&M assumptions apply)

Answer 1

a.

Value of Hugh Sweets Shops = $21.50 million

EBIT = $2,633,750

if there is no taxes, and firm is unlevered firm. So EBIT of firm is equal to net income of the firm.

So, cost of equity = $2,633,750 / $21,500,000

= 12.25%

Cost fo equity is 12.25% and Firm is unlevered that is zero debt in capital structure. So WACC is equal to cost of equity, So, Cost of equity and WACC is 12.25%.

b.

Unlevered cost of equity = 12.25%

So, Net Income = $21,500,00 × 12.25%

= $2,633,750.

Net Income of firm should be $2,633,750.

Tax rate = 40%

SO, EBIT = $2,633,750 / (1 - 40%)

= $4,389,583.33

EBIT value should be $4,389,583.33.

Cost fo equity is 12.25% and Firm is unlevered that is zero debt in capital structure. So WACC is equal to cost of equity, So, Cost of equity and WACC is 12.25%.