Bruce & Co. expects its EBIT to be $80,000 every year forever. The firm can borr

Question

Bruce & Co. expects its EBIT to be $80,000 every year forever. The firm can borrow at 4 percent. Bruce currently has no debt, and its cost of equity is 10 percent.

a. If the tax rate is 35 percent, what is the value of the firm?

b. What will the value be if Bruce borrows $122,000 and uses the proceeds to repurchase shares?

Bruce & Co. expects its EBIT to be $80,000 every year forever. The firm can borrow at 4 percent. Bruce currently has no debt, and its cost of equity is 10 percent.

a. If the tax rate is 35 percent, what is the value of the firm?

b. What will the value be if Bruce borrows $122,000 and uses the proceeds to repurchase shares?

Explanation / Answer

a ) value of firm = EBIT * (1 - tax rate)/cost of equity = 80000*(1 -0.35)/.1 = 520000

b) Net income = (EBIT - borrowing cost *debt)* (1 - tax rate) = (80000 - .04*122000) * ( 1 -0.35) = 48828

WACC = cost ot debt* (1 - tax rate) * debt/total asset + cost of equity* equity/total asset

= .04*(1 - .35) *122000/520000 + .1*(520000 - 122000)/520000 = 8.263%

value = net income/WACC = 48828/.08263 = 590862.8875

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