Question

Bruin Industries just issued $320,000 of perpetual 8 percent debt and used the proceeds to repurchase stock. The company expects to generate $135,000 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 15 percent, and the corporate tax rate is 40 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.)

  

Value of the company

$

  

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.)

  

Value of the company

$

  

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.)

  

Required return

%

  

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.)

  

Value of equity

$

Answer 1

a)

EBIT in pepetuity = $135000

Tax = 0.4 * $135000 = $54000

Net Income = $81000

unlevered cost of capital is 15 percent

Value of the Company (unlevered) = $81000/0.15 = $540000

b) Adjusted present value method to calculate the value of the company with leverage :

Present Value = Debt - After-Tax PV of debt

= $320000 - (1 - 0.4)*(0.08)*$320000/0.08

= $128000

According to APV,

APV = Value of the company (unlevered) + Present Value

=$540000 + $128000 = $668000

c) For the required rate of return on a firm's levered equity can be solved using Modigliani - miller equation:

Required Rate of return = 0.15 + (value of bond / value of equity)*(1 -Tax)*(0.15-0.08)

Value of Equity = $668000 - $320000 = $ 348000

0.15 + (320000/348000)*(1 - 0.4)*(0.07) = 18.862%

d) EBIT = $135000

Interest = 0.08 * 320000 = 25600

Earning before Tax = $109400

Tax = 0.4* $109400 = $43760

NI = $65640 (Cashflow available to equity holders)

Required rate of return for equity = 18.862%

Value of Equity = $65640/0.18862 = $348001.2724