Snowstorm Inc. expects its EBIT to be $300,000 every year forever. The firm can borrow at...
Snowstorm Inc. expects its EBIT to be $300,000 every year forever. The firm can borrow at 10%. The firm currently has no debt, and its cost of equity is 12%. The tax rate is 40%. The firm is thinking of borrowing $340,000 and using the proceeds to buy back shares.
a) What would be the debt to equity ratio?
Answer is 0.262 - need in-depth solution.
Homework Answers
Value of Unlevered Firm = EBIT * (1 - Tax Rate) / Unlevered Cost
of Equity
Value of Unlevered Firm = $300,000 * (1 - 0.40) / 0.12
Value of Unlevered Firm = $300,000 * 0.60 / 0.12
Value of Unlevered Firm = $1,500,000
Value of Levered Firm = Value of Unlevered Firm + Value of Debt
* Tax Rate
Value of Levered Firm = $1,500,000 + $340,000 * 0.40
Value of Levered Firm = $1,500,000 + $136,000
Value of Levered Firm = $1,636,000
Value of Equity = Value of Levered Firm - Value of Debt
Value of Equity = $1,636,000 - $340,000
Value of Equity = $1,296,000
Debt to Equity Ratio = Value of Debt / Value of Equity
Debt to Equity Ratio = $340,000 / $1,296,000
Debt to Equity Ratio = 0.262
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