Red hawk Enterprises expects EBITDA (a proxy for cash profits) to be $85,000 a y

Question

Red hawk Enterprises expects EBITDA (a proxy for cash profits) to be $85,000 a year in perpetuity. The firm can borrow at 9% but currently has no debt. Its unlevered cost of equity capital is 15% and its effective tax rate is 40%. Assume interest expense is tax deductible.

a. What us the value of Red hawk Enterprises as an all equity firm?

b. Red hawk wants to recapitalize the firm by issuing $250,000 in debt and buy back an equal amount of stock. What is the value of the levered firm after the recapitalization?

c. Using the value of the levered firm from (b), what is the value of the equity?

d. What is the cost of equity for the levered firm?

e. What is Red hawk’s required return on assets or WAAC after recapitalization?

Explanation / Answer

a) Cost of the firm = EBITDA/cost of equity = 85000/.15 =

566,666.67

b) The following shows the relation between levered equity expected returns, rl, and unlevered equity expected returns, ru

rl - rd = (ru - rd)[1 + (D/E)]

ru=unlevered equity cost = 15%, rd =debt rate= 9%, D/E = debt to equity = 250000/(566,666.67-250000)= 0.79

rl = 19.74%

Levered firm value = EBITDA/rl + D*t

where t = tax rate and D*t is the tax shield

Levered firm value = 85000/19.74%+250000*.4 = 530666.67

c) value of equity = 530666.67-250000= 280666.67

d) rf= 19.74%

e) WACC = debt% * debt rate * (1- tax rate)+ equity% * equity rate = (250000 /530666.67)* 9%*(1-0.4) + (280666.67/530666.67)*15% = 9.92%

c)

566,666.67

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