In: Finance
Assume the following data for two firms (U = unlevered firm) and (L = levered firm). Assume the two firms are in the same risk class when it comes to business risk. Both firms have EBIT = €1000 000. Firm U has zero debt and its required rate of return (KsU = 12%). Firm L has €2000 000 debt and pays 10% interest rate.
Based on the data provided, answer the following questions and show all your computations and interpret your results.
Where there is no tax
Where thare is no corporate tax , value of levered firm = value of unlevered firm
Value of unlevered form = EBIT/Required rate of return ( Since there is no tax PAT = EBIT)
= €1000 000/ 12%
= €8333333.33
Thus value of levered firm = €8333333.33
Value of equity + Value of debt = Value of firm
Thus €8333333.33 = Value of equity + €2000 000
Thus market value of equity of levered firm = €6333333.33
Market value of equity of levered firm = €2000 000
Where there Corporate tax = 60%
Value of unlevered firm = EBIT(1-tax rate)/Required rate of return
=€1000 000(1-60%)/12%
=€1000 000(0.4)/12%
= 40000/12%
=333333.33 €
Value of levered firm = Value of unlevered firm+ PV of interest shield
= 333333.33 € + (Loan amount x tax rate)
333333.33 € + (2000000 x 60%)
=333,333.33 + 1200,000
= 4533,333.33 €
Value of equity + Value of debt = Value of firm
Thus 4533,333.33 = Value of equity + €2000 000
Thus market value of equity of levered firm = €2533333.33
Market value of equity of levered firm = €2000 00