Jet Corporation expects an EBIT of $27,000 every year forever. The company curre

Question

Jet Corporation expects an EBIT of $27,000 every year forever. The company currently has no debt, and its cost of equity is 14 percent. The corporate tax rate is 35 percent.

a. What is the current value of the company?

b-1 Suppose the company can borrow at 9 percent. What will the value of the firm be if the company takes on debt equal to 40 percent of its unlevered value?

b-2 Suppose the company can borrow at 9 percent. What will the value of the firm be if the company takes on debt equal to 100 percent of its unlevered value?

c-1 What will the value of the firm be if the company takes on debt equal to 40 percent of its levered value?

c-2 What will the value of the firm be if the company takes on debt equal to 100 percent of its levered value?

Explanation / Answer

a. With no debt, the current value of an unlevered firm:

V = EBIT(1 – tC)/RU

V = $27,000(1 – 0.35)/0.14

V = $125357.14

b-1. If debt is 40% of unlevered value, the value of the levered firm is:

V = VU + tCD

V = $125357.14+ 0.35($125357.14*0.40)    

V = $142907.14

b-2. If debt is 100% of unlevered value, the value of the levered firm is:

V = VU + tCD

V = $125357.14+ 0.35($125357.14*1)

V = $169232.14

c-1. If debt is 40% of levered value, then D must equal to (V*0.40), so:

V = VU + tCD

V = $125357.14+ 0.35* V *0.40

V = $ 145764.12

c-2. If debt is 100% of levered value, then D must equal to (V*1), so:

V = VU + tCD

V = $125357.14+ 0.35* V *1

V = $ 192857.14

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