Question

In: Finance

Assume Chalktronics is for sale for $500,000 and the firm has the following characteristics: Cash sales:...

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.)

Expert Solution

The value of an unlevered firm is the present value of its after-tax earnings:

V_U = [(EBIT)(1-T_C)] / r₀

where V_U = the value of an unlevered firm

EBIT = the firm’s expected annual earnings before interest and taxes

T_C = the corporate tax rate

r₀ = the after-tax required rate of return on an all-equity firm

In this problem:

EBIT = $180,000

T_C = 0.40

r₀ = 0.20

The value of Chalktronics as an unlevered firm is:

V_U = [(EBIT)(1-T_C)] / 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

V_L = V_U + T_CB

where V_L = the value of a levered firm

V_U = the value of an unlevered firm

T_C = the corporate tax rate

B = the value of debt in a firm’s capital structure

In this problem:

V_U = $540,000

T_C = 0.40

B = $50,000

V_L = V_U + T_CB

= $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.

jeff jeffy answered 7 months ago

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