Question

a firm with no debt or earnings before interest and txes of $45,000, the firm expects to keep earning the same EBIT in all future years. The firm's cost of capital is 12 percent. There is no depreciation, capital expenditures, or net working capital.

a levered firm with the same operations and assets has $100,000 of debt, whose yield-to-maturity (pre-tax) is 6%. the firm expects to keep its debt at the same level in all future years.

the corporate tax rate is 20 percent.

what is the value of the LEVERED firm?

Answer 1

EBIT = $45,000

EBIT will be same in all future years thus, no growth rate of EBIT.

As there will be no Capital Expenditure, Depreciation and Net working capital,

Free cash flow(FCF) = EBIT(1-Tax rate)

FCF = $45,000(1-0.20)

FCF = $ 36,000

1) Value of Unlevered Firm = FCF/Cost of Unlevered equity

= $ 36000/12%

= $300,000

Note- In unlevered Firm, Cost of capital is equal to cost of Equity

2)

Value of levered Firm = Value of Unlevered firm + (Amount of Debt*tax rate)

= $300,000 + ($100,000*20%)

= $ 300,000 + $ 20,000

= $320,000

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