Use the following to answer questions 1-5: A firm has an expected perpetual EBIT
ID: 2650165 • Letter: U
Question
Use the following to answer questions 1-5:
A firm has an expected perpetual EBIT = $4,000. The unlevered cost of capital = 15% and there are 20,000 shares of stock outstanding. The firm is considering issuing $8,800 in new par bonds to add financial leverage to the firm. The proceeds of the debt issue will be used to repurchase equity. The cost of debt = 10%, and the tax rate = 34%.
1. What is the value of the firm before the restructuring? Assume there are no taxes.
A) $15,930
B) $17,600
C) $18,519
D) $26,667
E) $30,000
2. What is the value of the firm before the restructuring?
A) $15,930
B) $17,600
C) $18,519
D) $26,667
E) $30,000
3. What is the value of the firm after the restructuring?
A) $15,930
B) $17,600
C) $18,519
D) $20,592
E) $22,461
4. What is the value of the equity after the restructuring?
A) $11,792
B) $12,600
C) $12,819
D) $13,592
E) $16,461
5. What is the cost of equity after the restructuring? Assume the firm's market value is $20,592 after the restructuring.
A) 14.8%
B) 17.5%
C) 18.4%
D) 20.0%
E) 22.5%
Explanation / Answer
1. Value of firm = EBIT / cost of capital..................... [assumed with no taxes]
= $4,000 / 0.15
= $26,667
(D) $26,667
2. Value of firm = EBIT * (1 - tax rate) / cost of capital
= $4,000 * (1 - 34%) / 0.15
= $17,600
(B) $17,600
3. After restructuring,
Value of the firm = EBIT * (1 - tax rate) / cost of equity + Value of debt * tax rate
= $4,000 * (1 - 34%) / 0.15 + $8,800 * 34%
= $20,592
(D) $20,592
4. Value of Equity = Value of Firm - Value of Debt
= $20,592 - $8,800
= $11,792
(A) $11,792
5. Cost of Equity = (EBIT - Interest exp) * (1 - Tax rate) / (Value of Firm - Value of Debt)
= ($4,000 - 10% * $8,800) * (1 - 34%) / ($20,592 - $8,800)
= 17.5%
(B) 17.5%
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