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Fresno Industries is in the 21% corporate tax bracket. Its unlevered cost of capital is 10.5%....

Fresno Industries is in the 21% corporate tax bracket. Its unlevered cost of capital is 10.5%. The company has a policy of payout all of its earnings in dividends at the end of each year. Fresno just issued $325,000 of perpetual 7 percent debt. With the proceeds, it repurchased it stock. The company expects to generate $146,000 of earnings before interest and taxes in perpetuity.

a. What is the value of the company as an unlevered firm?

b. Use the adjusted present value method to calculate the value of the company with leverage.

c. What is the required return on the firm’s levered equity?

d. Use the flow to equity method to calculate the value of the company’s equity.

Solutions

Expert Solution

a) Unleavered firm value is the value of only the equity capital of the company.

Unleavered Cost of Capital = 10.50% ; Tax rate = 21% ; EBIT = $146,000

Earnings after Tax = EBIT *( 1 - tax rate)

= 146000 *(1 - 21%) = $ 115,340

Value of Unleavered firm = Earning after tax / cost of capital

= 115340 / 10.50% = $ 1,098,476

b) Value of company with leverage is given as below

= Value of unleavered firm + PV of Tax shield

Tax shield is the value of savings in taxes related to the interest paid on the Debt capital

Interest Tax Shield = Value of debt * Interest rate * Tax rate

= 325000 * 7% * 21%

= 325000 * 0.07 * 0.21 = $ 4777.5

Present value of Interest tax shield = Interest tax shield / interest rate

= 4777.5 / 7% = $ 68,250

So the value of company with leverage = 1,098,476 + 68,250 = $ 1,166,726

c) Required return on the firm’s levered equity is calculate as below

= Unlevered Cost of Capital + Debt equity ratio * (1-Tax Rate) * (Unlevered Cost of Capital - Cost of Debt)

Debt to Equity Ratio = Total Debt / Total Equity

Total Debt = $ 325,000

Total Equity = Value of leveared company - total debt

= 1166726 - 325000 = $ 841,726

Debt Equity ratio = 325000 / 841726 = 0.386

Required return = 10.5 + 0.386 * (1-21%) * ( 10.50 - 7 )

= 10.5 + 1.067 = 11.57%

d) Value of the company’s equity using flow to equity method is explained below

= Net Income / cost of leavered equity

Net Income = EBIT - Interest Expense - tax expense

EBIT = 146,000.

Interest Expense = 146,000 * 21% = $ 22,750

Profit before tax = $ 123,250

Tax expense = 123250 * 21% = $ 25,882.5

Net Income = 123,250 - 25,882.5 = 97,367.5

Value of the company’s equity = 97,367.5 / 11.57%

= $ 841,551.4

jeff jeffy answered 1 year ago

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