Question

Change Corporation expects an EBIT of $31,200 every year forever. The company currently has no debt, and its cost of equity is 11 percent.

a. What is the current value of the company?

b. Suppose the company can borrow at 6 percent. If the corporate tax rate is 22 percent, what will the value of the firm be if the company takes on debt equal to 50 percent of its unlevered value? What if it takes on debt equal to 100 percent of its unlevered value?

c. What will the value of the firm be if the company takes on debt equal to 50 percent of its levered value? What if the company takes on debt equal to 100 percent of its levered value?

Answer 1

a) What is the current value of the company?

Current value of the company = EBIT * (1−Corporate tax rate) / Cost of equity

= $31,200 * (1 - 0.22 ) / 0.11

= $ 221,236.36

b. Suppose the company can borrow at 6 percent. If the corporate tax rate is 22 percent, what will the value of the firm be if the company takes on debt equal to 50 percent of its unlevered value? What if it takes on debt equal to 100 percent of its unlevered value?

i) Takes debt on 50% of its unlevered:

Value of the company = Current value of the company + (corporate tax rate * Current value of the company * 40%)

= $ 221,236.36 + ( 0.22 * $ 221,236.36 * 0.5 )

= $245,572.36

ii) if it takes on debt equal to 100% of its unlevered :

Value of the company = Current value of the company + (Corporate tax rate * Current value of the company * 100%)

= $221,236.36 + ( 0.22 * $221,236.36 * 1.00 )

=$269,908.36

c. What will the value of the firm be if the company takes on debt equal to 50 percent of its levered value? What if the company takes on debt equal to 100 percent of its levered value?

i) Takes debt on 50% of its levered value:

Value of the Levered firm (VL) = Current value of the company + (corporate tax rate * Current value of the Levered firm * 50%)

VL = $ 221,236.36 + ( 0.22 * VL * 0.5)

VL = $ 221,236.36 + 0.11 VL

0.89VL = $ 221,236.36

VL = 248,580.18

ii)

i) Takes debt on 100% of its levered value:

Value of the Levered firm (VL) = Current value of the company + (corporate tax rate * Current value of the Levered firm * 100%)

VL = $ 221,236.36 + ( 0.22 * VL * 1.00)

VL = $ 221,236.36 + 0.22 VL

0.78VL = $ 221,236.36

VL = 283,636.36