Question

17. New Schools expects an EBIT of $100,000 every year forever. The firm currently has no debt, and its cost of equity is 10 percent. The firm can borrow at 6 percent and the corporate tax rate is 20 percent. What will the value of the firm be if it converts to 50 percent debt

Answer 1

$880,000

Explanation:

First note that the full meaning of EBIT is earning before interest and tax.

When the company does not have debt, it called unlevered (VU), while a company that has debt is called levered (VL) company. The VU and the VL of the company can be calculated using the VU and VL formula as follows:

Step 1. Calculation of VU

VU = [EBIT × (1 - tax rate)] ÷ cost of equity

= [$100,000 × (1 - 0.20)] ÷ 0.10

= [$100,000 × 0.80] ÷ 0.10

= $80,000 ÷ 0.10

= $800,000

Step 2. Calculation of VL

VL = VBC + (tax rate × conversion rate × VU)

= $800,000 + (0.20 × 0.5 × $800,000)

= $800,00 + $80,000

= $880,000

Therefore, the value of the firm will be $880,000 if it is converted to 50 percent debt.