A firm has an operating profit of $155,000, interest of $35,000 and a tax rate o

Question

A firm has an operating profit of $155,000, interest of $35,000 and a tax rate of 40%. The firm has an after tax cost of debt of 5% and a cost of equity of 15%. The firm' s target capital structure is set at a mix of40% debt and 60% equity. According to the traditional approach to capital. structure the value of the firm is
(Hint- there are two steps to solving this problem. The second step involves using the zero growth dividend valuation mathemaritical expression.)

A $1.4 million
B $2.0 million
C $2.7 million
D $6.0 million

Explanation / Answer

The required rate of return would be .40*.05 +.60*.15= .11 So if we use the zero growth dividend valuation model we have 155,000/.11= 1,409= 1.4 million (A).

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