Question

Now that your firm has matured, you are considering adding debt to your capital structure for the first time. Your all-equity firm has a market value of $21 million and you are considering issuing $2 million in debt with an interest rate of 5% and using it to repurchase shares. You pay a corporate tax rate of 40%. Assume taxes are the only imperfection and the debt is expected to be permanent.A. What will be the total value of the firm after the change in capital structure? B. What will be the value of the remaining equity after the change in capital structure?

Answer 1

Answer:

A. The total value of the firm after the change in capital structure is $21,800,000

B. The value of the remaining equity after the change in capital structure is $19,800,000

Explanation:

A. In order to calculate the total value of the firm after the change in capital structure we would have to make the following calculation:

total value of the firm after the change in capital structure=Value of unlevered firm+Debt*tax rate

According to the given data we have the following:

Value of unlevered firm=$21 million

Debt=$2 million

tax rate=40%

Therefore, total value of the firm after the change in capital structure=$21 million+$2 million*40%

total value of the firm after the change in capital structure=$21,800,000

B. To calculate the value of the remaining equity after the change in capital structure we would have to make the following calculation:

value of the remaining equity after the change in capital structure=total value of the firm after the change in capital structure-debt

value of the remaining equity after the change in capital structure=$21,800,000-$2,000,000

value of the remaining equity after the change in capital structure=$19,800,000