In: Finance
Assume Chalktronics is for sale for $500,000 and the firm has the following characteristics:
Cash sales: $600,000 per year forever
Cash costs: 70% of sales
Corporate tax rate: 40%
Unlevered cost of capital (r0): 20%
Both Pentronics and DebtTronics are interested in purchasing Chalktronics.
Pentronics will use no debt financing and DebtTronics will use a target D/E ratio of 10% to finance the acquisition.
A. What is the maximum Pentronics can pay for Chalktronics? (4 pts.)
B. What is the maximum DebtTronics can pay for Chalktronics? (4 pts.)
The value of an unlevered firm is the present value of its after-tax earnings:
VU = [(EBIT)(1-TC)] / r0
where VU = the value of an unlevered firm
EBIT = the firm’s expected annual earnings before interest and taxes
TC = the corporate tax rate
r0 = the after-tax required rate of return on an all-equity firm
In this problem:
EBIT = $180,000
TC = 0.40
r0 = 0.20
The value of Chalktronics as an unlevered firm is:
VU = [(EBIT)(1-TC)] / r0
= [($180,000)(1 - 0.40)] / 0.20
= $540,000
The value of Chalktronics is $540,000 as an all-equity firm.
The Value of Levered Firm is
VL = VU + TCB
where VL = the value of a levered firm
VU = the value of an unlevered firm
TC = the corporate tax rate
B = the value of debt in a firm’s capital structure
In this problem:
VU = $540,000
TC = 0.40
B = $50,000
VL = VU + TCB
= $540,000 + (0.40)($50,000)
= $560,000
Therefore, the value of Chalktronics will be $560,000 if the firm adds $50,000 of debt to its capital structure.