Answer the problem based on the fr odigliani and Miller Propositions. Assume (EB

Question

Answer the problem based on the fr odigliani and Miller Propositions. Assume (EBIT) of $1,000,000 every year company has earnings before interest and taxes t value t e firm also has perpetual bonds with the market v of debt is 8 percent. The firm's unlevered cost value of $2,000,000. The of capital is 15 percent. The forever. The firm also has before-tax cost tax rate is 25 percent. a) Find the value of the firm. b) Find the value of equity c) Find the firm's cost of equity d) Find the firm's weighted average cost of capital.

Explanation / Answer

(a) Perpetual EBIT = $ 1000000, Perpetual Bond = $ 2000000, Tax Rate = 25 %, Unlevered Cost of Capital = 15 %, Before Tax Cost of Debt = 8 %

Value of Firm as per MM proposition would be calculated by summing the unlevered firm value and the present value of interest tax shield.

Unlevered Firm Value = Vu = EBIT x (1-tax rate) / Unlevered Cost of Capital = 1000000 x (1-0.25) / 0.15 = $ 5000000

PV of Interest Tax Shield = Tax Rate x Market Value of Perpetual Debt = 0.25 x 2000000 = $ 500000

Total Firm Value = Vl = PV of Interest Tax Shield + Vu = 500000 + 5000000 = $ 5500000

(b) Equity Value = Vl - Perpetual Debt Value = 5500000 - 2000000 = $ 3500000

(c) Let the firm's cost of equity be Ke

Debt to Equity Ratio = 2000000 / 3500000 = (4/7)

Ke = Unlevered Cost of Equity + (DE Ratio) x (1-tax rate) x (Unlevered Cost of Equity - Cost of Debt) = 15 + (4/7) x (1-0.25) x (15 - 8) = 18 %

(d) Weighted Average Cost of Capital = (1-0.25) x (4/11) x 8 + 18 x (7/11) = 14.88 %

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