Suppose the Kumar Corporation has no debt and is asking whether issuance of debt

Question

Suppose the Kumar Corporation has no debt and is asking whether issuance of debt can
increase the company's value. The firm has annual earnings before interest and taxes of
$8,000,000. Their proposal is to borrow $6,000,000 in the form of perpetual debt (i.e., debt
that never matures). The company's management decides that the cost of equity for the
company is 12%. Kumar is planning to buy back its stock with the entire amount borrowed.
The company's tax bracket is 35%.
(a) Compute the company's value if they borrow.
(b) You know the company's nancial data and conclude that they made a mistake while
computing the cost of equity. You estimate the correct beta for unlevered rm to be 1.2.
Assume the risk-free interest rate is 7% and the market risk premium is 5%, Re-calculate
the value of the company with borrowing.

Explanation / Answer

(a) Compute the company's value if they borrow.

company's value = unlevered value + Debt*tax

company's value = 8000000*(1-35%)/12% + 6,000,000*35%=$45433333.33

(b) You know the company's financial data and conclude that they made a mistake while
computing the cost of equity. You estimate the correct beta for unlevered rm to be 1.2.
Assume the risk-free interest rate is 7% and the market risk premium is 5%, Re-calculate
the value of the company with borrowing.

Cost of equity = 7%+ 1.2*5%= 13%

company's value = 8000000*(1-35%)/13% + 6,000,000*35%=$42100000.0

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