In: Finance
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.
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