Question

Suppose the corporate tax rate is 40%. Consider a firm that earns $4,500 in earnings 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 7%. a. 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? b. Suppose instead the firm makes interest payments of $1,400 per year. What is the value of equity? What is the value of debt? c. What is the difference between the total value of the firm with leverage and without leverage? d. To what percentage of the value of the debt is the difference in part (c) equal? a. 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? If the firm has no debt and pays out its net income as a dividend each year, the value of the firm's equity is $ . (Round to the nearest dollar.) b. Suppose instead the firm makes interest payments of $1,400 per year. What is the value of equity? What is the value of debt? If the firm makes interest payments of $1,400 per year, the value of equity is $ 1. (Round to the nearest dollar.) If the firm makes interest payments of $1,400 per year, the value of debt is $ . (Round to the nearest dollar.) c. What is the difference between the total value of the firm with leverage and without leverage? The difference between the total value of the firm with leverage and without leverage is $ . (Round to the nearest dollar.) d. To what percentage of the value of the debt is the difference in part (c) equal? The percentage of the value of debt to the difference in part (c) is %. (Round to the nearest whole percent.)

Answer 1

If the firm has no debt, the value of its equity is $102 million. If the firm has debt and makes interest payments of $1,400 per year, the value of equity is $1 and the value of debt is $183 million. The difference between the total value of the firm with leverage and without leverage is $183 million.

Step-by-step explanation:

a. If the firm has no debt and pays out its net income as a dividend each year, the value of the firm's equity is $102 million.

b. If the firm makes interest payments of $1,400 per year, the value of equity is $1. The value of debt is $183 million.

c. The difference between the total value of the firm with leverage and without leverage is $183 million.

d. The percentage of the value of debt to the difference in part (c) is 100%.