Question

Alpha Corporation has earnings before interest and tax (EBIT) per annum in perpetuity of $200,000. The tax rate is 30%. The firm is funded $50,000 of debt and $150,000 of equity. The cost of equity is 18% and the cost of debt is 6%.

Given the information above, what is the appropriate discount rate if earnings after interest and before tax (EAIBT)is used to calculate the equity value of the firm?

	A.	20.79%
	B.	25.71%
	C.	18%
	D.	14.55%
	E.	None of the above

Answer 1

Answer-

When calculating equity value, levered free cash flows ie. cash flow available to equity shareholders are discounted by the cost of equity because the calculation is only concerned with what is left for equity investors.

Therefore the Correct Option is C. 18 %

Here Weighted average ost of capital (WACC) is not used as enterprise value, unlevered free cash flows ie. cash flow available to all shareholders are discounted by WACC as it includes what is available to all investors.

here WACC = Wt of debt x cost of debt x ( 1 - tax rate) + Wt of equity x cost of equity

WACC = 0.25 x 6 % x ( 1 - 0.3) + 0.75 x 18 %

[ Wt of debt = $ 50000 / ( $ 50000 + $150000) = $50000 / $ 200000 = 0.25 / Total capital = $ 50000 + $150000 = $ 200000 ]

WACC = 0.25 x 6 % x 0.7 + 0.75 x 18 %

WACC = 1.05 % + 13.5 %

WACC = 14.55 %

Here WACC cannot be used to calculate the equity value of the firm

Therefore option D is incorrect. Options A and B are incorrect.