O’Connell & Co. expects its EBIT to be $61,000 every year forever. The firm can
ID: 2802555 • Letter: O
Question
O’Connell & Co. expects its EBIT to be $61,000 every year forever. The firm can borrow at 7 percent. O’Connell currently has no debt, and its cost of equity is 14 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 $148,000 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 $61,000 every year forever. The firm can borrow at 7 percent. O’Connell currently has no debt, and its cost of equity is 14 percent.
Explanation / Answer
A. Value of firm:
= EBIT ( 1 - Tax rate ) / Cost of Equity
= $ 61,000 ( 1 - 0.35 ) / 14%
= $ 61,000 (0.65 ) /14%
= $ 39,650 / 14%
= $ 283,214.29
VALUE OF FIRM IF borrowed $ 148,000:
Value of Unlevered firm = $ 283,214.29
+ Tax shiled on Int = $ 3,626 (WN )
Value of Levered firm = $ 286,840.29
Working note:
Tax shiled on Interest
Borrow amount * Int rate * Tax rate
=( $148,000*7%*35%)
= $ 3,626
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