Cesar Digital Systems has EBIT of $500,000, a growth rate of 5%, and faces a tax

Question

Cesar Digital Systems has EBIT of $500,000, a growth rate of 5%, and faces a tax rate of 40%. In order to support growth, Cesar must reinvest 50 percent of its EBIT in net operating assets. Cesar has $400,000 in 10% debt outstanding. A similar company with no debt has a cost of equity of 12%. (Note that this problem assumes growth in earnings, otherwise referred to as MM extension with growth.

What is the value of the firm’s tax shield? a. $228,571.43 b. $714,285.71 c. $285,714.29 d. None of the above

According to the MM extension with growth, what is the firm’s unlevered value? a. $228,571.43 b. $714,285.71 c. $285,714.29 d. None of the above

Explanation / Answer

Solution:

Value of the firm's tax shield = value of debt + value of equity

Value of equity = 500000 - interest - tax

500000 - 40000 = 460000

Tax 40 % hence after tax profit = 276000

Reinvestment = 50% = 138000

hence the value of the firm = $714285

MM extension with growth

Firm's unlevered value = $285714

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.