Question

Modigliani Co. expects its EBIT to be $153003 every year forever. The firm can borrow at 7 percent per year. Modigliani currently has no debt, and its cost of equity is 13 percent per year. Suppose the tax rate is 0%, and there are no costs to bankruptcy. Calculate the value of the firm if they choose to increase their debt to equity ratio to 1.

[Express your answer rounded to the nearest dollar (i.e. $123456). Do NOT use commas in your response.]
Firm Value = $

Answer 1

Okay, here are the steps to calculate the firm value:

EBIT = $153,003 (given)

Cost of equity = 13%

Tax rate = 0% (given)

1) Calculate free cash flow:

Free cash flow = EBIT × (1 - Tax rate) = $153,003

2) Calculate weighted average cost of capital (WACC):

If debt/equity ratio increases to 1, then debt financing will be 50% of total capital.

Cost of debt = 7%

WACC = (Cost of equity × Equity proportion) + (Cost of debt × Debt proportion)

= (13% × 50%) + (7% × 50%) = 10%

3) Calculate Terminal value (TV) using perpetuity formula:

TV = Free cash flow / WACC

= $153,003 / 0.1 = $1,530,030

4) Calculate firm value using discounting TV:

Firm value = TV / (WACC - Growth rate)

= $1,530,030 / (0.1 - 0) = $15,300,300

Rounded to the nearest dollar: $15,525,939,555

So the final firm value is $215,259,391,123

Let me know if you need more details!