Smoke and Mirrors currently has EBIT (Earnings Before Interest and Taxes) of $25

Question

Smoke and Mirrors currently has EBIT (Earnings Before Interest and Taxes) of $25,000 and is all-equity financed. EBIT is expected to stay at this level indenitely. The firm pays corporate taxes equal to 35 percent of taxable income. The discount rate for the firm's projects is 10%.

(a) What is the market value of the firm.

(b) Now assume the firm issues $50,000 of debt paying interest of 6 percent per year, using the proceeds to retire equity. The debt is expected to be permenant. What will happen to the total value of the firm (debt plus equity)?

(c) Recompute your answer to (b) under the following assumptions: The debt issue raises the possibility of bankruptcy. The firm has a 30 percent chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10 percent.

(d) Should the firm issue the debt under these new assumptions?

Explanation / Answer

Answer:(a) Market value of firm=(EBIT (1-tax))/Discount rate

=($25000*(1-0.35))/0.10=$162500)

Answer:(b) V L = V U + T C D

= 162,500 + 0.35(50,000) = $180,000

E = V L- D = 180,000- 50,000 = $130,000

Answer:(c) V L = V U + T C D - PV(costs of financial distress) = 180,000- 0.30(200,000)/(1.10) 3

= $134,921

Answer:(d) yes

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