Question

Lazare Corporation expects an EBIT of $19,750 every year forever. Lazare currently has no debt, and its cost of equity is 15%. The firm can borrow at 10%. (Do not round intermediate calculations. Round the final answers to 2 decimal places. Omit $ sign in your response.)

a. If the corporate tax rate is 35%, what is the value of the firm?

Value of the firm         $

b. What will the value be if the company converts to 50% debt?

Value of the firm         $

c. What will the value be if the company converts to 100% debt?

Value of the firm         $

Answer 1

	Given,
	EBIT = $19750
	Cost of Equity = Ke = 15%
	Pre Tax Cost of Debt = 10%
	Corporate Tax Rate = 35%
	So,
a)	Value of Firm = EBIT (1-Tax Rate) / Cost of Equity
		= 19750 (1-35%) / 15%
		= 19750 (0.65) / 15%
		= 12837.50 / 15%
		= 85583.33
b)	Value of Firm when debt is 50%
	= EBIT (1-Tax Rate) / WACC
	Please noted that if debt portion is 50%, then equity portion
	will be 50%(100-50).
	Calculation of WACC
	Post Tax cost of debt = Pre tax cost of debt (1-Tax Rate)
		= 10% (1-35%)
		= 10% (0.65)
		= 6.50%
	Particulars	Weights (Wt)	Cost	Wt x Cost
	Debt	0.50	6.50	3.25
	Common Equity	0.50	15.00	7.5
			WACC	10.75
	Therefore, WACC = 10.75%
	Value of Firm when debt is 50%
	= EBIT (1-Tax Rate) / WACC
	= 19750 (1-35%) / 10.75%
	= 19750 (0.65) / 10.75%
	= 12837.50 / 10.75%
	= 119418.60
c)	Value of Firm when debt is 100%
	= EBIT (1-Tax Rate) / WACC
	Please noted that if debt portion is 100%, then equity portion
	will be 0%(100-100).
	Therefore, WACC = Post Tax Cost of Debt = 6.50% (As calculated in (b))
	Value of Firm when debt is 100%
	= EBIT (1-Tax Rate) / WACC
	= 19750 (1-35%) / 6.50%
	= 19750 (0.65) / 6.50%
	= 12837.50 / 6.50%
	= 197500