Question

In: Finance

Suppose the corporate tax rate is 30 %30%. Consider a firm that earns $ 3 comma...

Suppose the corporate tax rate is

30 %30%.

Consider a firm that earns

$ 3 comma 000$3,000

in earnings before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is

7 %7%.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity?

b. Suppose instead the firm makes interest payments of

$ 1 comma 700$1,700

per year. What is the value of equity? What is the value of debt?

c. What is the difference between the total value of the firm with leverage and without leverage?

d. To what percentage of the value of the debt is the difference in part

(c)

equal?

Solutions

Expert Solution

I'm POSTING THE QUESTION AGAIN WITH ANSWER WRITTEN BELOW THE QUESTION . THE REASON TO WRITE THIS IS I HAVENT BEEN DISPLAYED ABOUT THE ROUNDINGS OF DECIMAL PLACES FOR WHICH IM NOT RESPONSIBLE.

Suppose the corporate tax rate is

30 %30%.

Consider a firm that earns

$ 3 comma 000$3,000

7 %7%.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm's equity?

b. Suppose instead the firm makes interest payments of

$ 1 comma 700$1,700

per year. What is the value of equity? What is the value of debt?

c. What is the difference between the total value of the firm with leverage and without leverage?

d. To what percentage of the value of the debt is the difference in part

(c)equal?

PAT= EBIT*(1-TAX RATE) = 3000*(1-0.3)= 2100

Value of firms equity = PAT/ Rosk free rate= 2100/0.07= Value of firms equity = 30000

PAT= (EBIT-INTEREST EXPENSE) * (1-TAX RATE)

=(3000-1700) * (1-0.3) = 910

Value of Equity = 910/0.07= 13000

Valur of Debt= interest expense/ risk free rate

= 1700/0.07

Value of debt = 24285.7142857

Leverage means having both debt and equity

= 1300+24285.7142857

=37285.7142857

Without leverage means only equity financed

=30000

Difference = 37285.7142857-30000= 7285.7142857

Difference/ debt= 7285.7142857/24285.7142857

=30%

jeff jeffy answered 1 year ago

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