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The EBIT of a firm is INR 15 crores. The firm is currently allequity financed...

The EBIT of a firm is INR 15 crores. The firm is currently all equity financed at a cost of equity capital of 15%. The firm intends to lever up and change its capital structure by takingondebtofINR50croresinperpetuityasitprovides some value add to the firm. If the prevailing tax rate is 20%, what is the value of this firm before and after the change in capital structure? The firm is currently efficiently run and the shareholders are happy with the current earnings and do not intend to change the earnings in the future.

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Expert Solution

Current value of firm = EBIT*(1-t)/k0

EBIT = 15, t = 20%, k0 = 15%

Current value of firm = 15*(1-0.20)/0.15 = 80 crores

The value of all equity firm = value of unlevered firm = 80 crores

Now firm takes debt = 50 crores which is perpetual

So value of levered firm = Value of unlevered firm + Debt * tax rate

value of levered firm = 80 + 50*20% = 80 + 10 = 90 crores

Answers :

The value of firm before change in capital structure = 80 crores

The value of firm after change in capital structure = 90 crores

jeff jeffy answered 2 years ago
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