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

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.

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%.

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

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 9 months ago

Next > < Previous

Related Solutions

GRK Co. is currently an all-equity firm with an expected return of 10%. The expected EBIT...

GRK Co. is currently an all-equity firm with an expected return of 10%. The expected EBIT is $ 50,000 forever. Assume that the firm distributes all the net income to the equity holders. The firm is considering a leveraged recapitalization in which it would borrow $ 250,000 and repurchase existing shares. The firm's tax rate is 40%. The cost of debt is 7%. 1/ Calculate the value of the firm with leverage. 2/ Calculate the expected return of equity after...

The cost of equity capital is the rate of return investors expect to receive from investing...

The cost of equity capital is the rate of return investors expect to receive from investing in the firm’s stock. There are two primary methods for determining the cost of equity. One approach is to use the Dividend Growth Model to determine the required rate of return on the firm’s equity. A second approach is to use the Capital Asset Pricing Model (CAPM) to determine the expected or required rate of return for a firm’s stock. Explain which you would...

Bluegrass Mint Company has a debt-equity ratio of .25. The required return on the company’s unlevered...

Bluegrass Mint Company has a debt-equity ratio of .25. The required return on the company’s unlevered equity is 13.1 percent and the pretax cost of the firm’s debt is 6.9 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $20,000,000. Variable costs amount to 65 percent of sales. The tax rate is 24 percent and the company distributes all its earnings as dividends at the end of each year. a. If the...

Bluegrass Mint Company has a debt-equity ratio of .35. The required return on the company’s unlevered...

Bluegrass Mint Company has a debt-equity ratio of .35. The required return on the company’s unlevered equity is 13.6 percent and the pretax cost of the firm’s debt is 7.4 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $20,500,000. Variable costs amount to 70 percent of sales. The tax rate is 24 percent and the company distributes all its earnings as dividends at the end of each year. a. If...

Bluegrass Mint Company has a debt-equity ratio of .25. The required return on the company’s unlevered...

Bluegrass Mint Company has a debt-equity ratio of .25. The required return on the company’s unlevered equity is 12.5 percent and the pretax cost of the firm’s debt is 6.3 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $19,400,000. Variable costs amount to 60 percent of sales. The tax rate is 23 percent and the company distributes all its earnings as dividends at the end of each year. a. If...

Mojito Mint Company has a debt–equity ratio of .30. The required return on the company’s unlevered...

Mojito Mint Company has a debt–equity ratio of .30. The required return on the company’s unlevered equity is 13 percent, and the pretax cost of the firm’s debt is 7.8 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $18,300,000. Variable costs amount to 60 percent of sales. The tax rate is 34 percent, and the company distributes all its earnings as dividends at the end of each year. a. If...

Bluegrass Mint Company has a debt-equity ratio of .30. The required return on the company’s unlevered...

Bluegrass Mint Company has a debt-equity ratio of .30. The required return on the company’s unlevered equity is 13.2 percent and the pretax cost of the firm’s debt is 7 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $20,100,000. Variable costs amount to 70 percent of sales. The tax rate is 25 percent and the company distributes all its earnings as dividends at the end of each year. a. If...

Bluegrass Mint Company has a debt-equity ratio of .30. The required return on the company’s unlevered...

Bluegrass Mint Company has a debt-equity ratio of .30. The required return on the company’s unlevered equity is 12 percent and the pretax cost of the firm’s debt is 5.8 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $18,900,000. Variable costs amount to 70 percent of sales. The tax rate is 23 percent and the company distributes all its earnings as dividends at the end of each year. a. If...

Mojito Mint Company has a debt–equity ratio of .30. The required return on the company’s unlevered...

Mojito Mint Company has a debt–equity ratio of .30. The required return on the company’s unlevered equity is 14 percent, and the pretax cost of the firm’s debt is 7.1 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $17,600,000. Variable costs amount to 60 percent of sales. The tax rate is 40 percent, and the company distributes all its earnings as dividends at the end of each year. If the company...

Bluegrass Mint Company has a debt-equity ratio of .25. The required return on the company’s unlevered...

Bluegrass Mint Company has a debt-equity ratio of .25. The required return on the company’s unlevered equity is 11.9 percent and the pretax cost of the firm’s debt is 5.7 percent. Sales revenue for the company is expected to remain stable indefinitely at last year’s level of $18,800,000. Variable costs amount to 65 percent of sales. The tax rate is 22 percent and the company distributes all its earnings as dividends at the end of each year. a. If the...

Subjects