Corporate Finance: Timpano Inc. can each period have good sales with 50% probabi

Question

Corporate Finance:

Timpano Inc. can each period have good sales with 50% probability or bad sales with 50% probability. In case of good sales the unlevered cash flow will be $80 million, in case of bad sales the unlevered cash flow will be $50 million. The unlevered beta of the company is 1.5, the expected return of the market portfolio is 4% while the risk-free return is 1%. Timpano's equity market value is $850 million and its debt is kept constant at $950 million.

What is the corporate tax rate? (Assume that the firm's cash flow is perpetual).

Answer: 65.07%. (Its a past paper that I am trying to solve. So I had the answer. The purpose of posting the answer is to get the calculations, as I could not reach the answer.)

Explanation / Answer

unlevered cash flow = .5*80 +.5*50 = 65

cost of equity = IRF + (RISK PREMIUM)*BETA

                           1% + (3)1.5 = 5.5%

VALUE OF EQUITY = NI / Ke

850 = NI / 5.5%

NI = 850*.055 = 46.75

NET OPERATING INCOME - TAX = NET INCOME

65 - TAX = 46.75

TAX = 65 - 46.76 = 18.25

TAX RATE = 18.25/65 = .28076*100 = 28.07%

THIS IS THE CORRECT SOLOUTION

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