Please answer all (a) (b) (c) (d). A company currently has EBIT of $25,000 and i
ID: 2549571 • Letter: P
Question
Please answer all (a) (b) (c) (d). A company currently has EBIT of $25,000 and is financed entirely with equity. EBIT is expected to remain constant at this level indefinitely. The company pays taxes at a 35% effective rate. The discount rate for the company’s projects is 10%.
(a) What is the market value of the firm?
(b) Assume the company issues $50,000 of debt, paying interest at 6% per annum, and uses the proceeds to repurchase common stock. The debt is expected to be permanent. What will happen to the value of the company (debt plus equity)?
(c) Now consider the costs of financial distress. Assume the debt raises the probability of bankruptcy: the company has a 30% chance of going bankrupt in 3 years; bankruptcy costs are expected to be $100,000. the discount rate is 10%.
(d) Should the company issue debt considering both the tax shield and the costs of bankruptcy?
Explanation / Answer
(a) Market Value of Firm = Market Value of Equity+ Market Value of Debt
Market Value of Debt=0 as debt free company
Market Value of Equity= (Free Cash Flow+ Growth%)/(Discount rate- Growth Rate)
Free Cash Flow= EBIT- Interest-Taxes= 25000-35%= 16250
So Market Value= 16250/10%= 162500
(b) Free Cah Flow= EBIT- Interest-Taxes= 25000-(50000*6%) -35%= 14300
So Market Value of equity= 14300/10%= 143000
Value of Compamny= 143000+50000= 193000
(c) Firm Value= Unlevered Firm Value+ Tax Benefits of debt- Expected Bankrupcy Cost
= 162500+(50000*35%)-(100000*30%)= 150000
(d) No the company should not issue debt as it will reduce the value of company by 12500.
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