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Example2 New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 15 percent. The firm can borrow at 8 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt?

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Answer #1

Unlevered firm:

Value of Unlevered firm = 7,000 * (1 - 0.34)/ 0.15

Value of Unlevered firm = 30,800

Levered firm:

when levered, the value of debt is equal to one-half of the unlevered value of the firm.

Value of levered firm = 30,800 + 0.34 * 0.50 * 30,800

Value of levered firm = 36,036

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