Problem 4 (36 marks) Texas Inc. has an EBIT of $450,000 that it expects it wil e

Question

Problem 4 (36 marks) Texas Inc. has an EBIT of $450,000 that it expects it wil earn forever, and it pays all of its earnings as dividends to shareholders (i.e., no growth). The firm has a corporate tax rate of 40% and has an un-levered beta of .90. The firm has 92,656 common shares 2 issued and outstanding. In the market, you observe that Government T-bills are being sold to yield 4% and the S&P;/TSX Composite Index is expected to yield 10%. Assume a world of taxes and a cost for the risk of default. a) Calculate the value of the firm. (4 marks) b) Calculate the WACC for the firm. (2 marks) c) What is the value of a share in the company and what is the EPS? (4 marks) d) What is the value of the firm if the firm issues S600,000 of bonds at par with a coupon rate of 7.5%? The beta for the equity of the leveraged firm is 1.02. (10 marks) coupon rate of 8.5%? The beta for the equity of the leveraged firm is 1.40. (10 What is the optimal level of debt, S600,000 or $700,000? Explain. (2 marks) e) What is the value of the firm if the firm issues $700,000 of bonds at par witha f) g What is the WACC for the firm at the optimal level of debt? (4 marks)

Explanation / Answer

Cost of equity = 4% + 0.9*(10% - 4%) = 9.4%

PAT = 450000*(1-40%) = 270000

a)

Equity value = 270000 / 9.4% = 2872340

Firm has no debt, hence firm value is same as equity value

Firm value = 2872340

b)

Firm has no debt, hence WACC is same as cost of equity

WACC = 9.4%

c)

Value of share = 2872340 / 92656 = 31.00

EPS = 270000 / 92656 = 2.91

d)

new cost of equity = 4% + 1.02*(10% - 4%) = 10.12%

Equity value = 270000 / 10.12% = 2667984.19

Debt = 600000

Firm value = 2667984.19 + 600000 = 3267984.19

e)

new cost of equity = 4% + 1.4*(10% - 4%) = 12.4%

Equity value = 270000 / 12.4% = 2177419.35

Debt = 700000

Firm value = 2177419.35 + 700000 = 2877419.35

f and g)

Wd = 600000 / 3267984.19 = 18.36%

We = 1 - 18.36% = 81.64%

WACC = 18.36%*7.5%*(1-40%) + 81.64%*10.12% = 9.09%

Wd = 700000 / 2877419.35 = 24.33%

We = 1 - 24.33% = 75.67%

WACC = 24.33%*8.5%*(1-40%) + 75.67%*12.4% = 10.62%

Optimum level is when WACC is lower, hence 600000 is optimum level of debt, and WACC for that is 9.09%

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

---

---

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