Question

A company expects EBIT of 200000 every year into perpetuity. The firm currently has no debt, but it can borrow at 10% per annum. The company's cost of equity is 25% and the company is subject to a corporate tax rat of 35%.

If the company borrows 200,000 and uses the proceeds to repurchase equity, the value of the company would be:

Answer 1

After borrowing $200,000 and using the proceeds to repurchase equity, the value of the company would be $870,000, considering the corporate tax rate and the cost of equity.

Step-by-step explanation:

The value of the company after borrowing $200,000 given an EBIT of $200,000 into perpetuity, no initial debt, with a cost of equity at 25% and a corporate tax rate of 35% can be determined using the Modigliani-Miller theorem.

We calculate the unlevered value of the firm (Vu) using the formula: Vu = EBIT / cost of equity. Inserting the given numbers, Vu = $200,000 / 25%, which gives us Vu = $800,000.

With the tax shield benefit, the value of the levered firm (Vl) can be computed as:

Vl = Vu + (Debt × Tax rate) = $800,000 + ($200,000 × 35%) = $800,000 + $70,000 = $870,000.

Therefore, after borrowing $200,000 and repurchasing equity, the value of the company would be $870,000.