Question

Suppose a firm expects it’s EBIT to be 105,000 per year forever. Assume the firm can borrow at 6.75% ad has a tax rate of 32%. If the firm has no debt and a cost of equity of 10.25%, what is the value of the firm? ($696,585) Now suppose the firm borrows $120,000 and uses the proceeds to repurchase shares. Now what is the value of the firm?

Answer 1

Answer:

* If the firm has no debt, value of the firm = $696,585;

* If the firm borrows $120,000 and uses the proceeds to repurchase shares, value of the firm = $1,132,686.

Explanation:

* If the firm has no debt, value of the firm is calculated as: EBIT x ( 1- tax rate) / Cost of equity = 105,000 x ( 1- 32%) /10.25% = $696,585;

* If the firm borrows $120,000 and uses the proceeds to repurchase shares, value of the firm is calculated as below:

- New capital structure: Debt = 120,000; Equity = 696,585 - 120,000 = $576,585=> Debt + Equity = $696,585.

=> WACC= 10.25% x 576,585 / 696,585 + 6.75% x 120,000 * (1-32%) / 696,585 = 9.27%.

=> Value of the firm = EBIT / WACC = 105,000/9.27% = $1,132,686.