Question

An unlevered firm has a cost of capital of 13.6 percent and earnings before interest and taxes of $138,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $520,000 with an annual coupon of 7 percent. The applicable tax rate is 34 percent. What is the value of the levered firm

Answer 1

Value of levered firm is $846,506

Step-by-step explanation:

The value of levered firm will be the sum of value of the future incomes for the shareholder's at the cost of capital of un-levered firm discounted at cost of equity and the tax advantage of debt.

The value of equity = Profit before tax * (1 - Tax) / Cost of capital

The tax advantage = Value of debt * tax rate

Now putting the values in both above equation:

Value of equity = $138,000 (1 - 34%) / 13% = $6,69,706

The tax advantage of Debt = $520,000 * 34% = $176,800

Value of levered firm = $669,706 + $176,800 = $846,506