15. Redhawk Enterprises expects EBITDA (a proxy for cash profits) to be $85,000
ID: 2807233 • Letter: 1
Question
15. Redhawk Enterprises expects EBITDA (a proxy for cash profits) to be $85,000 a year in perpetuity. The firm can borrow at 9% but currently has no debt. Its unlevered cost of equity capital is 15% and its effective tax rate is 40%. Assume interest expense is tax deductible.
a. What is the value of Redhawk Enterprises as an all-equity firm (Vu)?
b. Redhawk wants to recapitalize the firm by issuing $250,000 in debt and buy back an equal amount of stock. What is the value of the levered firm (VL) after the recapitalization?
c. Using the value of the levered firms (VL) from part (B) above, what is value of the Equity?
d. What is the cost of equity for the levered firms?
e. What is Redhawk’s required return on assets or WACC after the recapitalization?
Explanation / Answer
EBITDA 85,000 Tax 34,000 ATCF 51,000 r 15% Value of the Firm=51000/15% 3,40,000 Value of levered Firm As per M&M Proposition II debt equity ratio =rE = r0 +D/E*(r0-rd)*(1-t) Where r0 is the cost of equity of the firm without debt r0=15% D/E=250000/(340000-250000) 2.78 rd=cost of debt 9% t=tax rate 40% re=15%+2.78*(15%-9%)*(1-.4) 25.01% EBITDA 85,000 Less: Interest 22,500 EBT 62,500 Tax 25,000 PAT 37,500 Add; Interest 22,500 Total EBIAT 60,000 Re 25.01% WACC=25.01%*90000/340000+9%*(1-.4)*250000/340000 10.59% Value of the Levered firm=60000/10.59% 5,66,572 Value of the Equity Total Value of the Firm 5,66,572 Less: Value of the Debt 2,50,000 Value of the Equity 3,16,572 Cost of the Equity of levered firm 25.01% WACC 10.59%
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