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.)

Solutions

Expert Solution

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.


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