Question

In: Finance

Ice Cream Sandwich Co. expects EBIT of $300,000 every year forever. Ice Cream Sandwich Co. currently...

Ice Cream Sandwich Co. expects EBIT of $300,000 every year forever. Ice Cream Sandwich Co. currently has no debt and its cost of equity is 20%. The firm can borrow at 5%. The corporate tax rate is 33%. The value of the firm is 1005000.

Questions:

a. what will be the value of the firm if Ice Cream Sandwich Co. borrows $280,000 of permanent debt and uses the proceeds to buy back stock?

b. how can Ice Cream Sandwich Co. maximize the value of the firm? What will be the maximum value if there are no costs to financial distress?

c. Suppose that with $280,000 of debt, there is a 13% probability of financial distress, in which case the firm will have a present value of $220,000. What is the value of the firm in this case? Recall that the value of the firm with $280,000 debt and no costs to financial distress was $1,097,400.

Answer for a. 1097400. b. 1500000 c. 983338. How can I get those answers? Please write in detail calculation, dont use the excel.

Solutions

Expert Solution

Perpetual EBIT = $300000, Since the company does not have any debt therefore the company is an unlevered firm and also cost of equity = Unlevered cost of equity = 20%

Perpetual Unlevered cash flow = Perpetual Free cash flow to firm = EBIT(1-tax rate) = 300000(1-33%) = 300000 x 67% = 201000

Value of unlevered firm   = Perpetual Unlevered cash flow / Unlevered cost of equity = 201000 / 20% = 201000 / 0.20 = 1005000

Hence value of firm = $1005000

a. Amount of permanent debt borrowed = $280000

In case of permanent debt being borrowed at fixed rate of interest, we know that

Value of firm with debt = Value of Levered firm = Value of unlevered firm + tax rate x amount of permanent debt borrowed

Value of firm with debt = 1005000 + 33% x 280000 = 1005000 + 92400 = $1097400

Hence Value of firm = $1097400

b. We know that debt provides interest tax shield to a firm. Interest tax shield results in tax savings and increases the cash flow to owners of the firm or free cash flow to firm. Higher the debt, higher will be interest expense associated with it. Higher interest expense results in greater interest tax shield and more tax savings. Therefore as the amount of debt increases, tax savings increases and also result in higher cash flow to owners of the firm or free cash flow to firm. We know the value of firm is equal present value of future free cash flow to the firm. Higher tax savings by the way of tax shield will result in higher present value of future cash flows and increase the value.the firm. Higher debt also increase cost of financial distress. As firm does not have any cost of financial distress, hence the firm will have maximum value when it will be 100% financed with debt.

When the firm is financed with 100%, then Equity = 0, and Value of levered firm = Equity + Debt = 0 + Debt = Debt

Now we also know that, Value of levered firm = Value of unlevered firm + debt x tax rate

Value of levered firm = Value of unlevered firm + Value of levered firm x tax rate

Value of levered firm = 1005000 + Value of levered firm x 33%

Value of levered firm - Value of levered firm x 33% = 1005000

Value of levered firm(1-33%) = 1005000

Value of levered firm = 1005000 /(1-33%) = 1005000 / 67% = 1500000

Hence maximum value of firm = $1500000

c. Probability of financial distress = 13%, Value of firm in case of financial distress = 220000

Probability of no financial distress = 1- Probability of financial distress = 1 - 13% = 87%

Value of firm in case of no financial distress = 1097400

Value of firm = Expected Value of firm = Probability of financial distress x Value of firm in case of financial distress + Probability of no financial distress x Value of firm in case of no financial distress = 13% x 220000 + 87% x 1097400 = 28600 + 954738 = $983338

Hence Value of firm = $983338


Related Solutions

Hunter Corporation expects an EBIT of $29,000 every year forever. The company currently has no debt...
Hunter Corporation expects an EBIT of $29,000 every year forever. The company currently has no debt and its cost of equity is 14 percent. The corporate tax rate is 24 percent.    a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b-1. Suppose the company can borrow at 8 percent. What will the value of the company be if takes on debt equal to 30...
Calvert Corporation expects an EBIT of $21,250 every year forever. The company currently has no debt,...
Calvert Corporation expects an EBIT of $21,250 every year forever. The company currently has no debt, and its cost of equity is 14.0 percent. The company can borrow at 8 percent and the corporate tax rate is 40. a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Value of the firm            $ b. What will the value of the firm be if the company takes...
Hunter Corporation expects an EBIT of $45,000 every year forever. The company currently has no debt...
Hunter Corporation expects an EBIT of $45,000 every year forever. The company currently has no debt and its cost of equity is 13 percent. The corporate tax rate is 23 percent. A .Suppose the company can borrow at 9 percent. What will the value of the company be if takes on debt equal to 40 percent of its unlevered value? B.Suppose the company can borrow at 9 percent. What will the value of the company be if takes on debt...
Full Moon Corporation expects an EBIT of $25,250 every year forever. The company currently has no...
Full Moon Corporation expects an EBIT of $25,250 every year forever. The company currently has no debt, and its cost of equity is 12 percent. The corporate tax rate is 35 percent. a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Current value           $   b-1 Suppose the company can borrow at 7 percent. What will the value of the firm be if the company...
Hunter Corporation expects an EBIT of $43,000 every year forever. The company currently has no debt...
Hunter Corporation expects an EBIT of $43,000 every year forever. The company currently has no debt and its cost of equity is 11 percent. The corporate tax rate is 21 percent.    a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b-1. Suppose the company can borrow at 8 percent. What will the value of the company be if takes on debt equal to 30...
Lazare Corporation expects an EBIT of $19,750 every year forever. Lazare currently has no debt, and...
Lazare Corporation expects an EBIT of $19,750 every year forever. Lazare currently has no debt, and its cost of equity is 15%. The firm can borrow at 10%. (Do not round intermediate calculations. Round the final answers to 2 decimal places. Omit $ sign in your response.) a. If the corporate tax rate is 35%, what is the value of the firm? Value of the firm         $ b. What will the value be if the company converts to 50% debt? Value...
Cavo Corporation expects an EBIT of $22,500 every year forever. The company currently has no debt,...
Cavo Corporation expects an EBIT of $22,500 every year forever. The company currently has no debt, and its cost of equity is 12 percent. The corporate tax rate is 35 percent.    a. What is the current value of the company? (Round your answer to 2 decimal places. (e.g., 32.16))      Current value $       b-1 Suppose the company can borrow at 7 percent. What will the value of the firm be if the company takes on debt equal to...
JC Cruises Corporation expects an EBIT of $24,225 every year forever. The company currently has no...
JC Cruises Corporation expects an EBIT of $24,225 every year forever. The company currently has no debt, and its cost of equity is 12.5 percent. The corporate tax rate is 35 percent.    a) What is the current value of the company? (Round your answer to 2 decimal places.) b) Suppose the company can borrow at 8 percent. What will the value of the firm be if the company takes on debt equal to 25 percent of its unlevered value?...
Hunter Corporation expects an EBIT of $27,000 every year forever. The company currently has no debt...
Hunter Corporation expects an EBIT of $27,000 every year forever. The company currently has no debt and its cost of equity is 13 percent. The corporate tax rate is 23 percent. a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b-1. Suppose the company can borrow at 7 percent. What will the value of the company be if takes on debt equal to 60 percent...
Change Corporation expects an EBIT of $53,000 every year forever. The company currently has no debt,...
Change Corporation expects an EBIT of $53,000 every year forever. The company currently has no debt, and its cost of equity is 15 percent. The corporate tax rate is 21 percent. a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b-1. Suppose the company can borrow at 12 percent. What will the value of the firm be if the company takes on debt equal to...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT