11. An investment costs $10,000 and is expected to produce EBIT of $2,000 (in ca
ID: 2760711 • Letter: 1
Question
11. An investment costs $10,000 and is expected to produce EBIT of $2,000 (in cash) forever. The market’s all-equity required return on similar-risk assets is rA = 10%. You are considering two alternatives.
a) Unlevered: Investing the $10,000 as equity and issuing 1,000 shares at a par value of $10 per share.
b) Levered: Investing the $10,000 and issuing yourself $8,000 in risk-free perpetual debt at the market rate of rD = 8% and 200 shares at a par value of $10 per share. In this case, the $10,000 investment would be financed with $8,000 in debt and $2,000 in equity.
In either case, you intend to hold all the debt and the equity. Also, recall that V = CF/r for a perpetuity.
a. Complete the missing fields in the income statement below:
Unlevered Levered
Earnings (as cash flow) before interest & taxes $2,000 $2,000
Less: Interest _________ _________
Earnings before taxes (as cash flow) _________ _________
Less: Taxes (TC= 35%) _________ _________
Earnings (as cash flow) _________ _________
Cash flow to both debt and equity _________ _________
b. Find the value of the levered firm VLaccording to MM’s Proposition I VL= VU+ TCD.
c. Find the equity required return (rE) according to MM’s Proposition II rE = rA + (D/E)(rA-rD)(1-TC).
d. Find the market value of debt by discounting interest payments to debt at the cost of debt; D = CF(D)/rD.
e. Find the equity market value by discounting equity cash flows at the equity required return; E = CF(E)/rE.
f. Find the weighted average cost of capital rWACC = (D/V)rD(1-TC) + (E/V)rE of the levered firm.
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