Lone Star Industries just issued $280,000 of perpetual 8 percent debt and used t
ID: 2648920 • Letter: L
Question
Lone Star Industries just issued $280,000 of perpetual 8 percent debt and used the proceeds to repurchase stock. The company expects to generate $127.000 of earnings before interest and taxes in perpetuity. The company distributes all its earnings as dividends at the end of each year. The firm?s unlevered cost of capital is 15 percent, and the corporate tax rate is 40 percent. a. What is the value of the company as an unlevered firm? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Value of the company b. Use the adjusted present value method to calculate the value of the company with leverage. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Value of the company c. What is the required return on the firm?s levered equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Required return d. Use the flow to equity method to calculate the value of the company?s equity. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Value of the companyExplanation / Answer
Answer: a Calculation of the value of the company as an unlevered firm: Since the company is an all-equity firm, its value equals the present value of its unlevered net income, discounted at its unlevered cost of capital. Its net income is:
Net income = EBIT (1 - Tax)
=127000 (1- .40) =$76200
Hence, the value of the company is:
Vu =[ EBIT (1 -tax)]/Ro
=$76200/0.15
=$508000
Answer: b. Use the adjusted present value method to calculate the value of the company with leverage:
The adjusted present value of a firm equals its value under all-equity financing plus the net present value of any financing side effects. In this case, the NPV of financing side effects equals the after-tax present value of cash flows resulting from debt. Given a known level of debt, debt cash flows should be discounted at the pretax cost of debt, so
NPVF = tc * B
=0.40 * 280000
= $112000
Using the APV method, the value of the company is:
APV =Vu +NPVF
=508000+112000
=$620000
Answer: c. Calculation of the required return on the firm
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