Question

Problem 19.5.2 Question Help Debtfree Plc, an all-equity financed company, has annual earnings of £119m before tax per year, which are expected to remain stable in the future. The cost of the firm's capital is 10%, and the corporate tax rate is 35%. Debty Plc is in all respects a similar company to Debtfree Plc, but its capital structure includes £251 m of bonds. The value of the ungeared firm is £ 773.5 m. (round to one decimal place) The value of the geared firm is £ m. (round to two decimal places)

Answer 1

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

Value of ungeared firm = Earning before interest and taxes*(1-Tax rate)/ Cost of capital

                                       = £119 million*(1- 0.35)/ 10%

                                       = £773.50 million

Hence, the value of the ungeared firm is £773.50 million.

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

Value of ungeared firm = (Earning before interest and taxes*(1- Tax rate)/ Cost of capital) + (Debt*Taxes)

                                       = (£119 million*(1- 0.35)/ 10%) + (£251 million*35%)

                                       = £773.50 million + £87.85 million

                                       = £861.35 million

Hence, the value of the geared firm is £861.35 million.