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

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?

A)

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

B)

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

C)

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

D)

Difference/ debt= 7285.7142857/24285.7142857

=30%


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