Question

Calvert Corporation expects an EBIT of $21,250 every year forever. The company currently has no debt, and its cost of equity is 14.0 percent. The company can borrow at 8 percent and the corporate tax rate is 40.

a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value of the firm            $

b. What will the value of the firm be if the company takes on debt equal to 50 percent of its unlevered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value of the firm            $

What will the value of the firm be if the company takes on debt equal to 100 percent of its unlevered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value of the firm            $

c. What will the value of the firm be if the company takes on debt equal to 50 percent of its levered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value of the firm            $

Answer 1

Answer a.

EBIT = $21,250
Cost of Equity, R0 = 14.0%
Tax Rate, Tc = 40%

Value of Unlevered Firm, VU = EBIT * (1 - Tc) / R0
Value of Unlevered Firm, VU = $21,250 * (1 - 0.40) / 0.14
Value of Unlevered Firm, VU = $12,750 / 0.14
Value of Unlevered Firm, VU = $91,071.43

Answer b.

If debt is 50% of unlevered firm:

Value of Debt, B = 50% * VU
Value of Debt, B = 50% * $91,071.43
Value of Debt, B = $45,535.715

Value of Levered Firm, VL = VU + Tc * B
Value of Levered Firm, VL = $91,071.43 + 0.40 * $45,535.715
Value of Levered Firm, VL = $109,285.72

If debt is 100% of unlevered firm:

Value of Debt, B = 100% * VU
Value of Debt, B = 100% * $91,071.43
Value of Debt, B = $91,071.43

Value of Levered Firm, VL = VU + Tc * B
Value of Levered Firm, VL = $91,071.43 + 0.40 * $91,071.43
Value of Levered Firm, VL = $127,500.00

Answer c.

If debt is 50% of levered firm:

Value of Debt, B = 50% * VL

Value of Levered Firm, VL = VU + Tc * B
VL = $91,071.43 + 0.40 * 50% * VL
0.80 * VL = $91,071.43
VL = $113,839.29

Value of firm is $113,839.29