Question

In: Finance

Libby Co. is an unlevered firm. Investors currently expect a 12.75% return on the company’s equity....

  1. Libby Co. is an unlevered firm. Investors currently expect a 12.75% return on the company’s equity. The company is subject to a 24% corporate tax rate.

  1. If earnings before taxes are expected to be $15.85m per year forever, calculate the total value of this company.

Now suppose this company wants to shift its capital structure to add debt. It wants to issue $31.5 million of perpetual debt at a cost of 5.5%.

  1. Use the FTE method to calculate the value of the company’s equity after the recapitalization.
  2. What is the total value of the company after the recapitalization?
  3. Using MMII with taxes, what should be the total value of the company after issuing the debt?
  4. What is the debt-equity ratio of this company after the recapitalization?

Suppose the levered company is looking to invest in a new project. The project costs $27 million and will be financed at the debt-equity ratio you calculated in d. The project generates EBIT of $5.9 million in perpetuity.

  1. Would you advise Libby to invest in this project? (Hint: use the FTE method…be sure to show how much borrowing you will do and what annual interest costs will be).

Solutions

Expert Solution

a. Before tax earnings = 15,850,000

After tax earnings = Before tax earnings *(1- tax rate) = 15,850,000*(1-0.24) = 12,046,000

Total value of the company = after tax earnings/ return on equity =12,046,000/0.1275 = 94,478,431.37

Total value of the company =$94,478,431.37

b. Value of company's equity = 94,478,431.37 - 31,500,000 = 62,978,431.37

c. Some shares are repurchased and then new debt is issues. Theoritically the value of the company should not change. Hence value of the business = $94,478,431.37

d. As per the MM II with taxes, the value of the firm will increase with debt since the interest on debt is a tax deductible.

So value of firm = Unlevered value = Tax rate * debt issued

Value of the firm = $94,478,431.37 + 31,500,000*0.24

Value of the firm = $102,038,431.41

e. Debt equity ratio = Total debt/total equity = 31,500,000/62,978,431.37 = 0.50

f. Based on the interest rate of debt. we decide whether to invest or not.Let us assume debt has a 6% interest

So, WACC = 1/3 *6*(1-0.24) + 2/3 *12.75 = 10%

Net present value of the investment = 5.9/0.10 -27 Million = 32 million.

Since the net present value is positive, I would suggest Libby to invest in the project

jeff jeffy answered 1 year ago
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