Question

Dakota Co. has expected earnings before interest and taxes of $8,100, an unlevered cost of capital of 10 percent, and debt with both a book and face value of $14,000. The debt has an 8 coupon. The tax rate is 34 percent. What is the value of the firm?

Answer 1

NOTE: The firm would be valued using the APV method of valuation. This method first values the firm without any financing effect as a pure equity financed entity. This is followed by valuing the firm's interest tax shield and adding it to the pure equity financed value, thereby determining the firm's overall value. In this context, the firm is assumed to have perpetual (permanent) debt, thereby ensuring that the tax shields are discounted at the cost of debt.

EBIT = $ 8100, Tax Rate = t = 34 5

NOPAT = EBIT x (1-t) = 8100 x (1-0.34) = $ 5346

Unlevered Cost of Equity = 10%

Pure Equity Financed Value = 5346 / 0.1 = $ 53460

Interest Tax Shield = 0.08 x 14000 x 0.34 = $380.8

PV of Interest Tax Shield = 380.8 / 0.08 = $ 4760 (in the absence of any explicit cost of debt number we assume that the firm's interest rate (coupon rate) is the cost of debt)

Firm Value = All Equity Financed Value + PV of Interest Tax Shield = 53460 + 4760 = $ 58220

NOTE: There is considerable debate regarding the appropriate discount rate for the interest tax shield. Although we have discounted the same by the cost of debt, in many cases the company's tax shield could have risk similar to the company's unlevered equity. The appropriate discount factor in such a case would be the firm's unlevered cost of equity.