O’Connell & Co. expects its EBIT to be $52,000 every year forever. The firm can
ID: 2652157 • Letter: O
Question
O’Connell & Co. expects its EBIT to be $52,000 every year forever. The firm can borrow at 9 percent. O’Connell currently has no debt, and its cost of equity is 12 percent.
If the tax rate is 35 percent, what is the value of the firm? (Round your answer to 2 decimal places. (e.g., 32.16))
What will the value be if the company borrows $129,000 and uses the proceeds to repurchase shares?(Round your answer to 2 decimal places. (e.g., 32.16))
O’Connell & Co. expects its EBIT to be $52,000 every year forever. The firm can borrow at 9 percent. O’Connell currently has no debt, and its cost of equity is 12 percent.
Explanation / Answer
1) EBIT = 52000
Tax rate = 35%
Earning after tax = EBIT (1- Tax rate)
= (52000-0.35) i.e 33800
Value of firm = Earning available for equity shareholders / Cost of equity
= 33800/0.12 i.e 281667
2) Shares repurchased = 129000
Value of debt = 129000
Interest = 129000*9% i.e 11610
Value of equity after repurchase = 281667-129000 i.e 152667
WACC = 129000/281667*9(1-0.35) +152667/281667*0.12
= 2.68%+6.50% i.e 9.18%
Earning available for equity shareholders = EBIT - Interest - Tax
= 52000-11610- 14136
= 26254
Value of firm = 26254/9.18% i.e 285991
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