Suppose the corporate tax rate is 35%. Consider a firm that earns $2,000 in earnings before...

Suppose the corporate tax rate is 35%. Consider a firm that earns $2,000 in earnings before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 7%.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity?

b. Suppose instead the firm makes interest payments of $ 1,400 per year. What is the value of equity? What is the value of debt?

c. What is the difference between the total value of the firm with leverage and without leverage?

d. To what percentage of the value of the debt is the difference in part (c) equal?

Solutions

Expert Solution

A.cashflow to Equity = EBIT*(1-tax rate)
2000*(1-0.35)
1300
Risk free rate=   7%

value of firm = cash flow to Equity/Risk free rate
1300/7%
18571.42857
So value of Equity =   18571.42857

B
If interest paid=   $1,400
Cash flow to Equity = (EBIT- Interest)*(1-tax rate)
(2000-1400)*(1-0.35)
=$ 390

Value of Equity = 390/7%
5571.428571

Value of Equity is $5571.43

Value of debt = Cash flow to debt/Risk free rate
= 1400/7%=
20000

Value of debt is$20000

C.
Total value of Firm = Value of debt = Value of Equity
20000+5571.43
$25,571.43
"Difference in Total value of Levergae and unleveraged value of Firm
"
25571.43-18571.43
$7,000.00

Difference in % of Debt= 7000/20000
0.35   or 35%

So 35 percentage of the value of the debt is the difference in part (c) equal.

jeff jeffy answered 4 months ago

Next > < Previous

Related Solutions

Suppose the corporate tax rate is 30%. Consider a firm that earns $1,500 in earnings before...

Suppose the corporate tax rate is 30%. Consider a firm that earns $1,500 in earnings before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 7%. a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity? b. Suppose instead...

Suppose the corporate tax rate is 30%. Consider a firm that earns $1,500 before interest and...

Suppose the corporate tax rate is 30%. Consider a firm that earns $1,500 before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 4%. a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity? b. Suppose instead the firm...

Suppose the corporate tax rate is 40%. Consider a firm that earns $2,500 before interest and...

Suppose the corporate tax rate is 40%. Consider a firm that earns $2,500 before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 4%. a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity? b. Suppose instead the firm...

Suppose the corporate tax rate is 30 %30%. Consider a firm that earns $ 3 comma...

Suppose the corporate tax rate is 30 %30%. Consider a firm that earns $ 3 comma 000$3,000 in earnings before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 7 %7%. a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the...

A C corporation earns $4.30 per share before taxes. The corporate tax rate is 35%, the...

A C corporation earns $4.30 per share before taxes. The corporate tax rate is 35%, the personal tax rate on dividends is 20%, and the personal tax rate on non-dividend income is 39%. What is the total amount of taxes paid if the company pays a $3.00 dividend?

Consider a S corporation. The corporation earns $2 per share before taxes. The corporate tax rate...

Consider a S corporation. The corporation earns $2 per share before taxes. The corporate tax rate is 35%, the tax rate on dividend income is 20%, and the personal income tax rate is set at 28%. What are the shareholder's earnings from the corporation after all corresponding taxes are paid?

Suppose the corporate tax rate is 35%, and investors pay a tax rate of 15% on...

Suppose the corporate tax rate is 35%, and investors pay a tax rate of 15% on income from dividends or capital gains and a tax rate of 37.3% on interest income. Your firm decides to add debt so it will pay an additional $20 million in interest each year. It will pay this interest expense by cutting its dividend. a. How much will debt holders receive after paying taxes on the interest they earn? b. By how much will the...

Suppose the corporate tax rate is 35%, and investors pay a personal tax rate of 25%...

Suppose the corporate tax rate is 35%, and investors pay a personal tax rate of 25% on income from dividends or capital gains and a personal tax rate of 32.4% on interest income. Your firm decides to add debt so it will pay an additional $30 million in interest each year. It will pay this interest expense by cutting its dividend. a. How much will debt holders receive after paying taxes on the interest they earn? b. By how much...

A C corporation earns $5.90 per share before taxes. Thecorporate tax rate is 35%, the...

A C corporation earns $5.90 per share before taxes. The corporate tax rate is 35%, the personal tax rate on dividends is 20%, and the personal tax rate on non-dividend income is 39%. What is the total amount of taxes paid if the company pays a $2.00 dividend?A. $2.47B. $1.97C. $2.96D. $3.45

A C corporation earns $12.82 per share before taxes. The corporate tax rate is 39%, the...

A C corporation earns $12.82 per share before taxes. The corporate tax rate is 39%, the personal tax rate on dividends is 15%, and the personal tax rate on non-dividend income is 36%. What is the total amount of taxes paid if the company pays a $6.66 dividend?

Subjects