Question

Bird Enterprises has no debt. Its current total value is $47.2 million. Assume the company sells $18.5 million in debt.

a. Ignoring taxes, what is the debt-equity ratio?

b. Assume the company’s tax rate is 21 percent. What is the debt-equity ratio

Answer 1

a. Value of the firm = Value of the debt + Value of the equity

$47,200,000 = $18,500,000 + Value of the equity

Value of the equity = $47,200,000 - $18,500,000

Value of the equity = $28,700,000

Debt-equity ratio = $18,500,000 / $28,700,000

Debt-equity ratio = 0.64

b. With taxes, the value of the firm is:

Value of the firm = V_U + T_CD

Value of the firm = $47,200,000 + 0.21($18,500,000)

Value of the firm = $51,085,000

With taxes, the debt-equity ratio becomes:

V = E + D

$51,085,000 = E + $18,500,000

E = $32,585,000

Debt-equity ratio = $18,500,000 / $32,585,000

Debt-equity ratio = 0.57