Calculating Firm and Market Value
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Problem:
Overtime Corporation expects an EBIT of $35,000 every year forever. Overtime Corporation currently has no debt, and its cost of equity is 14 percent. The company can borrow at 8 percent. If the corporate tax rate is 38 percent, what is the value of firm? What will the value be if the company converts to 50 percent debt? To 75 percent debt? To 100 percent debt? What does this tell you about the relationship between the debt-equity ratio and the value of the interest tax shield?
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Solution Summary
The solution calculates the firm value for overtime corporations. The relationship between debt-equity ratio and the value of interest tax shield is determined.
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Value of an all equity Firm with constant earnings every year =Earnings after tax / Cost of unlevered equity
Runlevered = 14% (unlevered is a situation when firm has 0% debt).
EBIT = 35000
Interest = 0 (since the firm has zero debt)
EBT = 35000
Tax @38%=13300
EAT=21700
value of th firm =V unlevered = 21700/14%= $155,000
According to MM hypothesis, value of a levered firm = value of an unlevered firm + value of the ...
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