A firm has an expected perpetual EBIT = $6,000. The unlevered cost of capital =
ID: 2755786 • Letter: A
Question
A firm has an expected perpetual EBIT = $6,000. The unlevered cost of capital = 8% and there are 20,000 shares of stock outstanding. The firm is considering issuing $10,000 in new par bonds to add financial leverage to the firm. The proceeds of the debt issue will be used to repurchase equity. The cost of debt = 5% and the tax rate is 34%. There are no flotation costs.
What is the value of the firm before restructuring?
What is the value of the firm after restructuring?
What is the value of the equity after restructuring?
What is the cost of equity after restructuring?
Explanation / Answer
a) Value of the firm before restructuring:
= EBIT ( 1 - tax) / cost of unleverage
= $6000 ( 1 - 0.34) / 0.08
= $3960/ 0.08
= $49500
b) Value of the firm after restructuring :
= unleravge firm value + Present value of tax shield
= $49500 + (0.34 * $10000)
= $49500 + $3400
= $52900
Note:- Present Value of Tax shield = Tax rate * Bond value
It is because, when company issues Bond or Debt , there will be tax shield in respect to interest on Bond or Debt.
d) Cost of equity after restructuring :
cost of Leverage equity = cost of unleverage equity + Debt /Equity (cost of unleverage equity - cost of debt) (1-tax)
= 0.08 + 0.20(0.08 - 0.05) (1 - 0.34)
= 0.08 + 0.00396
= 0.08396
=8.396%
Note:- Debt / equity
= $10000 / $49500
= 0.20
Equity is taken as unleverage firm value
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