Question

Bruin Industries just issued $415,000 of perpetual 7.4 percent debt and used the proceeds to repurchase stock. The company expects to generate $200,000 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 12.4 percent and the corporate tax rate is 23 percent.

  

a.	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.)
b.	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.)
c.	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.)
d.	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.)

Answer 1

a	Value of unlevered firm:
	EBIT	$           200,000
	Less: taxes @23%	$            (46,000)
	Earnings available to equity holders	$           154,000
	Divided by unlevered cost of equity	12.40%
	Value of unlevered firm	$ 1,241,935.48
b	Adjusted present value method:
	Value of levered firm
	Debt issued	$     415,000.00
	× rate of interest	7.40%
	Interest on debt	$       30,710.00
	× tax rate	23%
	Tax saved on debt interest	$          7,063.30
	Divided by rate of interest	7.40%
	NPV of interest savings	$       95,450.00
	Add: value of unlevered firm	$ 1,241,935.48
	Value of levered firm	$ 1,337,385.48
c	Required return on levered equity:
	Value of levered firm	$ 1,337,385.48
	less: debt value (a)	$     415,000.00
	Market value of levered equity (b)	$     922,385.48
	(1): (a) divided by (b)	0.44992035
	(2): (1 - tax rate)	0.77
	Required return on unlevered equity	12.400%
	Less: pretax cost of debt	7.400%
	(3):	5.000%
	(1) × (2) × (3)	1.7322%
	Add: unlevered equity cost	12.400%
	Required return on levered equity	14.132%
d	EBIT	$     200,000.00
	Less: interest on debt	$      (30,710.00)
	EBT	$     169,290.00
	Less: taxes @23%	$      (38,936.70)
	Earnings available to equity holders	$     130,353.30
	Divided by levered cost of equity	14.132%
	Value of unlevered firm	$     922,385.48

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