Two firms, No Leverage, Inc. and High Leverage Inc.have equallevels of operating

Question

Two firms, No Leverage, Inc. and High Leverage Inc.have equallevels of operating risk and differ only in their capitalstructure. No Leverage is unlevered and High Leverage has$500,000 of perpetual debt in its capital structure. Assumethat the perpetural annual income of both firms available for stockholders is paid out as dividends. Hence, the growth rate forboth firms is zero. The income tax rate for both firms is40%. Assume that there are no financial distress costs oragency costs. Given the follow data:                                                                         NoLeverageInc.                  HighLeverage Inc Equity in CapitalStructure                                    $1,000,000                          $500,000 Cost of Equity,Ke                                                                10%                                     13% Debt in CapitalStructure                                          -----                                 $500,000 Pretax cost of debtKd                                                          ------                                    7% Net operating income(EBIT)                                 $100,000                             $100,000 determine the: a) Market value of No Leverage Inc. b) Market value of High Leverage Inc. c) Present value of the tax shield to high Leverage Inc. Two firms, No Leverage, Inc. and High Leverage Inc.have equallevels of operating risk and differ only in their capitalstructure. No Leverage is unlevered and High Leverage has$500,000 of perpetual debt in its capital structure. Assumethat the perpetural annual income of both firms available for stockholders is paid out as dividends. Hence, the growth rate forboth firms is zero. The income tax rate for both firms is40%. Assume that there are no financial distress costs oragency costs. Given the follow data:                                                                         NoLeverageInc.                  HighLeverage Inc Equity in CapitalStructure                                    $1,000,000                          $500,000 Cost of Equity,Ke                                                                10%                                     13% Debt in CapitalStructure                                          -----                                 $500,000 Pretax cost of debtKd                                                          ------                                    7% Net operating income(EBIT)                                 $100,000                             $100,000 determine the: a) Market value of No Leverage Inc. b) Market value of High Leverage Inc. c) Present value of the tax shield to high Leverage Inc.

Explanation / Answer

No Leverage Inc.

High Leverage Inc.

No Leverage Inc.

High Leverage Inc.

EBIT (Net Operating Income) $100,000 $100,000 Less: Interest (7% on debt)                         --- $35,000 Earnings Before Tax (EBT) $100,000 $65,000 Less: Tax (40%) $40,000 $26,000 Net Income $60,000 $39,000 (a) Market Value of No LeverageInc. = $60,000 / 0.10   = $600,000 (b) Market Value of High Leverage Inc =[$39,000 / 0.13 + $35,000/0.07] = $800,000 ( c) Tax Shield on High Leverage Inc. =$500,000 * 0.40 = $200,000

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