Question

Gary Electronics has an EBIT of $200,000, zero growth and its tax rate is 40%. Gary has $600,000 debt outstanding (8% before-tax cost of debt), and a similar company with no debt has a cost of equity of 10%.

a) What is the unlevered firm value if Gary does not have debt?

b) Using the compressed adjusted present value model, what is the value of Gary’s tax shield?

c) Using the compressed adjusted present value model, what is Gary’s value of operation?

Answer 1

Solution:

a)Calculation of unlevered firm

Earning for unlevered firm=EBIT(1-tax rate)

=$200,000(1-0.40)

=$120,000

Value of Gary=Earning for unlevered firm/Cost of equity

=$120,000/10%

=$1200,000

Thus,unlevered firm value if Gary does not have debt is $1200,000.

b)Calculation of value of Gary’s tax shield

Present Value of Tax shield=Interest*Tax rate/Cost of debt

=($600,000*8%)(0.40)/8%

=$240,000

c)Calculaton of  Gary’s value of operation

Present Value of Debt=Interest Expense*Tax rate/Cost of debt

=$240,000

Value of Operation=Value of Unlevered Firm+Present value of debt

=$1200,000+$240,000

=$1440,000