Question

Bruin Industries just issued $295,000 of perpetual 7 percent debt and used the proceeds to repurchase stock. The company expects to generate $130,000 of earnings before interest and taxes in perpetuity. The company distributes all its earnings as dividends at the end of each year. The firm’s unlevered cost of capital is 12 percent, and the corporate tax rate is 40 percent. What is the value of the company as an unlevered firm? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of the company $    Use the adjusted present value method to calculate the value of the company with leverage. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of the company $    What is the required return on the firm’s levered equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)      Required return % Use the flow to equity method to calculate the value of the company’s equity. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of equity $

Answer 1

1)

The company expects to generate $130,000 of earnings before interest and taxes in perpetuity.

EBIT = 130000

Earning after tax = EBIT ( 1 -tax rate)

= 130000 ( 1- 40%)

= 78000

The firm’s unlevered cost of capital is 12 percent

value of the company as an unlevered firm = 78000 / 0.12

=650000 $

2)

Value of the company (APV)= The value of the un-levered firm + the net value of the debt financing.

Bruin Industries just issued $295,000 of perpetual 7 percent debt and used the proceeds to repurchase stock

The net value of the debt financing. = 295000 - [( 295000 * 7% * (1-40%))/ 12%]

=191750

APV= 650000 + 191750

= 841750 $

3)

The levered return Re formula is shown below,

Re  = Ro + D/E ( Ro - Rd ) (1-tax rate)

Where ,Re = Levered cost of equity

Ro = Unlevered cost of equity = 12%

Rd = cost of debt = 7%

D/E =debt to equity ratio

Debt = 295000

Equity of the firm = Levered value of firm - debt

= 841750 - 295000 = 546750

Hence,

Re = 12% + ( 295000/ 546750) *(12% - 7% ) *(1-40%)

= 13.62 %

4)

EBIT = 130,000

Interest exp = 7% * 295000 = 20650

Earnings after interest and before tax = 130000 - 20650= 109350

Tax = 40% * 109350 = 43740

Earnings after Interest & tax= 109350 - 43740 = 65610

This will be the cash flow available to company shareholders

Value of equity Using the flow to equity method = cash flow available to company shareholders/ levered return

= 65610/ 13.62%

= 481765.6 $