Question

Stevenson's Bakery is an all-equity firm that has projected perpetual earnings before interest and taxes of $138,000 a year. The cost of equity is 13.7 per cent and the tax rate is 32 per cent. The firm can borrow money at 6.75 per cent. Currently, the firm is considering converting to a debt-equity ratio of 0.45. What is the firm's levered value?

A) $527,613

B) $829,507

C) $752,987

D) $689,919

E) $903,682

Answer 1

The levered value of Stevenson's Bakery is calculated using the Modigliani and Miller Proposition II with corporate taxes method, considering the EBIT, cost of equity, tax rate, and the planned debt-equity ratio.

Step-by-step explanation:

To calculate Stevenson's Bakery's levered value, we need to use the Modigliani and Miller Proposition II with corporate taxes. This method requires us to adjust the project earnings before interest and taxes (EBIT) by taking taxes into account, and then adding the tax shield benefit of the debt:

Unlevered Value (VU) = EBIT x (1 - Tax Rate) / Cost of Equity

= $138,000 x (1 - 0.32) / 0.137

= $93,960 / 0.137

= $685,693 (rounded to nearest dollar)

Tax Shield = Debt x Tax Rate

To find the debt level, we need to use the firm's target debt-equity ratio (D/E = 0.45). To find the equity (E), use the unlevered value (VU) and the D/E ratio:

Debt (D) = VU x (D/E) / (1 + D/E)

= $685,693 x 0.45 / (1 + 0.45)

= $685,693 x 0.45 / 1.45

= $213,228 (rounded to nearest dollar)

Now, calculate the tax shield:

Tax Shield = $213,228 x 0.32

= $68,233 (rounded to nearest dollar)

The levered value of the firm (VL) is the unlevered value (VU) plus the tax shield:

Levered Value (VL) = VU + Tax Shield

= $685,693 + $68,233

= $753,926 (rounded to nearest dollar)

However, since the levered value we calculated is not one of the options provided, we should re-check our calculations for accuracy.