Question

Marvin & Co. expects its EBIT to be $55,000 every year forever. The firm can borrow at 8 percent. Marvin currently has no debt, and its cost of equity is 12 percent. If the tax rate is 40 percent, what is the value of the firm? (Do not round intermediate calculations. Round your answer to 2 decimal places, e.g., 32.16.)

Value of the firm = $_______

Hint: there is no Interest, so EBIT x (1-t) gives you NI. Since it is a perpetuity, NI/r gives you the value of the firm.

What will the value be if the company borrows $145,000 and uses the proceeds to repurchase shares? (Do not round intermediate calculations. Round your answer to 2 decimal places, e.g., 32.16.)

Value of the firm = $______

Hint: This is a Miller Modigliani question with tax. Take the all-equity value of the firm from the previous question and add to it the value of the perpetual debt tax shield equal to the tax rate times the value of the Debt.

Answer 1

a)
Value of firm = (EBIT * (1 - t)) / cost of equity

= ($55,000 * (1 - 0.40)) / 12%

= $33,000 / 0.12

= $275,000

Value of firm = $275,000

b)

Value of firm = Value of unlevered firm + (debt * tax rate)
= $275,000 + ($145,000 * 40%)
= $275,000 + $58,000
= $333,000