25, River Cruises is currently 100% financed by equity with 58,000 shares. It no

Question

25, River Cruises is currently 100% financed by equity with 58,000 shares. It now proposes to issue $330,000 of debt at an interest rate of 10%. The proceeds will be used to repurchase 33,000 shares. Corporate tax rate is 35%. How will this debt financing change the after-tax cash flow to equity holders and to all investors (i.e. debtholders and equity holders combined) if the earnings before interest and tax is 96,000? You need to show the changes in cash flow, and the level of cash flow before and after the refinancing. (Hint: Draw a simple income statement will help with the flow.) 26. A company has expected earnings before interest and taxes (EBIT) of $3,800, an unlevered cost of capital of 15.4 percent and a tax rate of 35 percent. The company also has $2,600 of debt with a coupon rate of 5.7 percent. The debt is selling at par value. When a debt is selling at par, its required rate of return is the same as the coupon rate. What is the value of this levered firm? (Hint: this is similar to problem 16-20 in the homework. You can value a 100% equity financed company as the present value of a constant perpetuity, which is the after-tax EBIT. Now the company has some debt, the present value of tax shield is the value added to the unlevered firm.)

Explanation / Answer

Answer for Que 25.

Ebit = 96000

Net profit is the cash flow which is available to equity holders in particular. For debt holders we are subtracting the interest as it will be given to them.

Before issuance of debt

After issuance of debt.

Thus change in cash flow to equity investors = Net profit after debt issuance - net profit before debt issuance
= 40950 - 62400 = - 21450

Change in cash flow to debt holders = interest after debt issuance - interest before debt issuance
= 33000-0 = 33000

Answer for Q 26.

Levered cost of capital = (unlevered cost of capital ) / (1- tax rate) = (15.4/100)/(1-(35/100)) = 23.69

Interest = (5.7*2600)/100 = 148.2

Value of 100% equity financed company = Present value of constant perpetuity = after-tax ebit = ebit - tax = 3800-1278.13 =$ 2521.87

Present value of tax shield = (35/100) * 148.2 = 51.87
Value of levered firm = equity + debt - cash = 2521.87+ 2600 = $5121.87

EBIT 96000 Interest 0 EBIT - Interest = EBT 96000 Tax 33600 EBT - Tax = Net Profit 62400

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