Question

19. Old Schools expects an EBIT of $100,000 every year forever. The firm currently has no debt, and its cost of equity is 10 percent. The firm can borrow at 8 percent and the corporate tax rate is 20 percent. What will the value of the firm be if it converts to 50 percent debt? (40 percent of the levered firm value.) A. $8,895,870.11 B. $1,250,000 D. $680,000.00 E. None of the above.

Answer 1

The value of the firm is the discounted present value of the free cash flows

value of unlevered firm = 100,000 * (1 - 20%) / 10%= $800,000

If the firm converts to 50% of debt, the value of its debt will be 800,000 * 50% = 400,000.

According to the Modigliani-Miller theorem, the value of the levered firm will be:

value of levered firm = value of unlevered firm + value of debt * tax rate

value of levered firm = 800,000+ 400,000 * 20%

value of levered firm = $880,000

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