O’Connell & Co. expects its EBIT to be $78,000 every year forever. The firm can

Question

O’Connell & Co. expects its EBIT to be $78,000 every year forever. The firm can borrow at 7 percent. O’Connell currently has no debt, and its cost of equity is 12 percent.

If the tax rate is 35 percent, what is the value of the firm? (Round your answer to 2 decimal places. (e.g., 32.16))

What will the value be if the company borrows $103,000 and uses the proceeds to repurchase shares? (Round your answer to 2 decimal places. (e.g., 32.16))

O’Connell & Co. expects its EBIT to be $78,000 every year forever. The firm can borrow at 7 percent. O’Connell currently has no debt, and its cost of equity is 12 percent.

Explanation / Answer

(A)

Value of firm will be the present value of all future cash flows (EAT), discounted at its Cost of Capital.

Since currently firm has no debts, its cost of debt is irrelevant & we have to take its cost of equity as the discount rate.

Since annual expected EBIT = $78,000,

EAT = EBIT x (1 - Tax rate) = $78,000 x (1 - 0.35) = $ 50,700 per year

So Value of firm = $50,700 / 0.12 = $422,500.00

(b)

Now, Firm has borrowed $103,000 (at 7% interest) to repurchase shares.

So, it has to pay post-tax interest expense of = $103,000 x 0.07 x (1 - 0.35) = $4,686.50 per year, from its EBT of $ 50,700.

So revised EBT = $50,700 - $4,686.50 = $ 46,013.50 per year.

In this case, firm has both a Cost of Debt (7%) & Cost of Equity (12%). In absence of proportion of debt & equity, we have to calculate the Average Cost of Capital as an average of costs of debt & of equity.

So our discount rate = Average COC = (12% + 7%) / 2 = 9.5%

So Value of firm = $ 46,013.50 / 0.095 = $ 484,352.63

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