Question

Problem 16-14 MM and Taxes (LO2] Meyer & Co. expects its EBIT to be $116,000 every year forever. The firm can borrow at 8 percent. The company currently has no debt, and its cost of equity is 14 percent. a. If the tax rate is 25 percent, what is the value of the firm? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. What will the value be if the company borrows $260,000 and uses the proceeds to repurchase shares? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) a. Value of the firm Value of the firm

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Answer 1

(a)

Compute the value of the firm, using the equation as shown below:

Value of firm = EBIT*(1 – Tax rate)/ Cost of equity

                       = $116,000*(1 – 0.25)/ 14%

                       = $621,428.57

Hence, the value of the firm is $621,428.57.

(b)

Compute the value of the firm, using the equation as shown below:

Value of firm = {EBIT*(1 – Tax rate)/ Cost of equity} + (Debt capital*Tax rate)

                       = {$116,000*(1 – 0.25)/ 14%} + ($260,000*25%)

                       = $621,428.571428 + $65,000

                       = $686,428.57

Hence, the value of the firm is $686,428.57.