Question

QC Corporation expects an EBIT of $7,500 every year forever. Because it has no depreciable assets, this is also equivalent to its operating cash flows. QC currently has no debt, giving it an equity beta of 1.4. The firm could borrow at 9.6%, with a debt beta of .2, but this would increase the equity beta to 1.9. There are no corporate income taxes, the risk-free rate is 6%, the return on the market portfolio is 10%.

a. What is the current value of the unlevered firm?

b. What is the value of the firm if it changes its capital structure to include 50% debt.

Answer 1

Risk free rate=6%
market return=10%
equity beta 1.4
expected return=risk free rate+beta(market return-risk free rate)
Expected return=6%+1.4(10%-6%)
ER=11.6%
(a)
current value of unlevered firm=7500/11.6%
current value=64655.17
(b)
If firm changes its capital structure
50% debt 50% equity
WACC=WD*cost of debt+WE* cost of equity
WACC=(0.5*9.6%)+(0.5*11.6%)
WACC=10.6
value of the firm=7500/10.6%
Value of the firm=70754
Alternatively
beta of the company=(1.4*0.5)+(0.5*2)
beta of company=1.7
expected return=risk free rate+beta(market return-risk free rate)
Expected return=6%+1.7(10%-6%)
ER=12.8%
value of the firm=7500/12.8%
Value of the firm=58593.75