O’Connell & Co. expects its EBIT to be $49,000 every year forever. The firm can

Question

O’Connell & Co. expects its EBIT to be $49,000 every year forever. The firm can borrow at 8 percent. O’Connell currently has no debt, and its cost of equity is 11 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 $142,000 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 $49,000 every year forever. The firm can borrow at 8 percent. O’Connell currently has no debt, and its cost of equity is 11 percent.

Explanation / Answer

For a no-growth firm, we can assume in free cash flow formula (for simplicity)

FCF = EBIT(1-t) + Depreciation – CAPX – NWC

Depreciation = 0 and CAPX = 0, NWC = 0

Therefore we have

Firm Value = EBIT (1-t) / k

Where k is the cost of capital that is 11% and t is the tax rate, that is 35 %

We have EBIT = $ 49,000

So

Firm value = 49000 * (1-.35) / 0.11 = 31850/ 0.11 = $ 289,545.45

Here we don’t have debt so the weighted average cost of capital is also 11%

The value be if the company borrows $142,000 and uses the proceeds to repurchase shares

The value firm = $289,545.45 + .35($142,000)

                        = $339,245.45

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