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Question 1 Roger Corporation operating out of Mount Hope is seeking to determines it’s cost of...

Question 1

Roger Corporation operating out of Mount Hope is seeking to determines it’s cost of equity. Roger has an unlevered cost of capital of 10 percent, a tax rate of 25 percent, and expected EBIT of $8,500,000. Roger has $14,500,000 of Bond debt outstanding that pays a 8 percent coupon interest annually that is currently selling at par value. What is the cost of equity?

Question 2

Richard’s Enterprises expects its EBIT to be $138,000 every year forever. The firm can borrow at 9 percent. Richard currently has no debt, and its cost of equity is 9 percent. If the tax rate is 25 percent, what is the value of the firm? What will the value be if the company borrows $95,000 and uses the proceeds to repurchase shares?

Expert Solution

Solution to question no. 1

Calculation of Total Capital
	Amont in $
EBIT	8,500,000
Less: Tax @ 25%	2,125,000
After Tax Income	6,375,000
Cost of capital	10%
Total Capital (After tax Income / cost of capital)	63,750,000

Calculation of Cost of Equity
	Amont in $
Bonds	14,500,000
Interest rate on Bonds	8%
Interest amount	1,160,000

EBIT	8,500,000
Less: Interest on Bonds	1,160,000
Income before tax	7,340,000
Less: Tax @25%	1,835,000
After Tax Income (available for equity)	5,505,000

Total Capital (as calculated above)	63,750,000
Less: Bonds	14,500,000
Equity Investment	49,250,000

Cost of Equity (Return for equity / Equity Investment)	11.18%

Cost of equity is 11.18%

Solution to question no. 2

Richard's EBIT = $138,000

Tax rate = 25%

Earning after tax = Earning before tax - Tax

= $138,000 - (25% of $138,000) = $138,000 - $34,500 = $103,500

Cost of equity = 9%

then, Value of Firm = Earning available for equity / Cost of equity %

= $103,500 / 9%

= $1,150,000 (Value of Firm)

What will the value be if the company borrows $95,000 and uses the proceeds to repurchase shares:

Richard's EBIT = $138,000

Tax rate = 25%

Use $95,000 for purchase of shares.

Interest rate = 9%

Earning Before Tax = EBIT - Interest

= $138,000 - (9% on 95,000) = $138,000 - $8,550 = $129,450

Earning after tax = Earning before tax - Tax

= $129,450 - (25% of $129,450) = $129,450 - $32,362.50 = $97,087.50

then, Value of Firm = Earning available for equity / Cost of equity %

= $ 97,087.50 / 9%

= $1,078,050 (Value of Firm)

ekkarill92 answered 3 years ago

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