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.
