Question

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 were financed entirely by equity, how much would it be worth? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of the company $       b. 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 %    c-1. Use the weighted average cost of capital method to calculate the value of the company. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of the company $       c-2. What is the value of the company’s equity? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of equity $       c-3. What is the value of the company’s debt? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of debt $       d. Use the flow to equity method to calculate the value of the company’s equity. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)      Value of equity $

Answer 1

a).

Sales	1,76,00,000
Less: Variable cost	1,05,60,000
EBIT	70,40,000
Tax @ 40%	28,16,000
Net earnings	42,24,000

Unlevered after-tax earnings (Eu) = 4,224,000

Value of the unlevered firm Vu = Eu/unlevered equity return = 4,224,000/14% = 30,171,428.57

b). Return on levered equity = r0 + (D/E)(r0-rD)(1-T)

where

r0 = return on unlevered equity = 14%

D/E = debt to equity ratio = 0.3

rD = pre-tax cost of debt = 71.% and T = tax rate = 40%

rL = 14% + (0.3*(14%-7.1%)*(1-40%)) = 15.24%

c-1). D/E = 0.3 so (D+E)/E = 1.3

or E/V = 1/1.3 = 0.769

D/V = 1-E/V = 1-0.769 = 0.231

After-tax cost of debt kd = 7.1%*(1-tax rate) = 7.1%*(1-40%) = 4.26%

ke = 15.24% (calculated in part b)

WACC = kd*D/V + ke*E/V = (4.26%*0.231) + (15.24%*0.769) = 12.71%

Value of the firm using WACC = unlevered after-tax earnings/WACC = 4,224,000/12.71% = 33,246,339.79

c-2). Value of equity = E/V*Value of the firm = 0.769*33,246,339.79 = 25,566,435.30

c-3). Value of debt = Value of the firm - value of equity = 33,246,339.79 - 25,566,435.30 = 7,679,904.49

d).

Formula	Sales	1,76,00,000
	Less: Variable cost	1,05,60,000
	EBIT	70,40,000
	Debt	76,54,023
7.1% of debt	Less: interest expense	5,43,435.61
(EBIT-Interest exp.)	EBT	64,96,564.39
	Tax @40%	25,98,625.76
	Net earnings	38,97,938.63
	FCFE	38,97,938.63
	Cost of levered equity	15.24%
(FCFE/cost of equity)	Value of equity	25,573,669.01