A company is an all-equity firm that has projected earnings before interest and

Question

A company is an all-equity firm that has projected earnings before interest and taxes (EBIT) of $500,000 forever. The current cost of equity is 15% and the tax rate is 33%. The company is in the process of issuing $1.5 million of bonds at par that carry a 6% annual coupon. What is the unlevered value of the firm (in millions)? (Note: You should use MM capital structure model with corporate taxes, but without personal taxes and bankruptcy costs.)

$2.05 million

$2.23 million

$2.86 million

$3.50 million

According to the information from Question 9, what is the levered value of the firm (in millions)?_______

$3.95 million

$3.76 million

$3.22 million

$2.96 million

$2.05 million

$2.23 million

$2.86 million

$3.50 million

Explanation / Answer

EBIT = $500,000
cost of equity = 15%
tax rate = 33%

PAT = 500,000*0.67 = 335000

Value of unlevered firm = PAT/r = 335000/0.15 = $2,233,333.33 i.e choice B.

As per MM-I, Value of levered firm = Value of unlevered firm + tax * value of debt

= $2,233,333.33 + 0.33*1,500,000 = $2,233,333.33 + 495000 = $2,728,333.33 i.e none of the given choices.

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