15. Redhawk Enterprises expects EBITDA (a proxy for cash profits) to be $85,000

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

Alright so there's currently no interest cost for Redhawk. Thus tax will be paid on the whole of EBITDA. With that being said, let's answer the questions.

Part A

The left column carries the explanation to all the calculations I've made. We have the unlevered firm's value to be $340,000.

Part B

Now let's say that there's also a debt of $250,000 in Redhawk, we're supposed to find out the value of Redhawk with leverage. For this purpose however, just know that debt will always be valued at its face value here.

Thus the value of levered firm is higher than the value of unlevered firm.

Part C

We computed the value of Equity to be $250,000 above already!

Part D

Under the Net Income approach of Capital Structure, the cost of individual capital components will be the same regardless of the mix. Thus cost of capital will continue to be 15%.

Hope that helps!

Don't forget to upvote! :)

(in $) EBITDA     85,000.00 -Tax Cost @40% of EBITDA (34,000.00) Profit after Tax     51,000.00 Cost of Equity 15% Value of Firm (Profits divided by Cost) 340,000.00

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