Question

Suppose the corporate tax rate for Company A is 39%. Consider a firm that earns $1473 before interest and taxes each year with no risk. The firm’s capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 5.34%. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm’s equity?

Answer 1

The value of the firm's equity is calculated by first determining net income by deducting taxes from earnings and then dividing this by the risk-free interest rate. The net income is $898.53, and dividing by the 5.34% risk-free rate gives an equity value of approximately $16,831.46.

Step-by-step explanation:

The question asks how to calculate the value of a firm's equity, given that it has a corporate tax rate of 39%, earns $1473 annually before interest and taxes, and it will have no capital expenditures or changes in net working capital. Additionally, the firm pays out its net income as a dividend each year, and the risk-free interest rate provided is 5.34%.

First, the net income of the firm needs to be calculated by subtracting taxes from the earnings before interest and taxes (EBIT). The net income is therefore $1473 - ($1473 × 39%) = $1473 - $574.47 = $898.53. Once we have the net income, we can determine the value of the firm’s equity by dividing the net income by the risk-free interest rate. This stems from the concept that the value of an asset is the present value of its future cash flows, which in this case, is the net income as it is all paid out in dividends.

Hence, the value of the equity is $898.53 / 0.0534 = approximately $16,831.46 (since the interest rate is expressed as a decimal).