Question

O’Connell & Co. expects its EBIT to be $83,000 every year forever. The firm can borrow at 11 percent. O’Connell currently has no debt, and its cost of equity is 15 percent.

1. If the tax rate is 35 percent, what is the value of the firm? (Round your answer to 2 decimal places. (e.g., 32.16)


2. What will the value be if the company borrows $144,000 and uses the proceeds to repurchase shares? (Round your answer to 2 decimal places. (e.g., 32.16))

Answer 1

1. $3,59,666.66

2. $4,10,066.66

Step-by-step explanation:

1. The computation of value of firm is shown below:-

As the Earning before interest and tax given remains the same, this impact that there is no growth rate in the earnings to consider.

= Earning before interest and tax × (1 - Tax) ÷ Cost of equity

= $83,000 × (1 - 0.35) ÷ (0.15)

= $53,950 ÷ 0.15

= $3,59,666.66

2. The computation of value of levered firm is shown below:-

Value of unlevered firm + Debt × Tax rate

= 3,59,666.66 + ($144,000 × 35%)

= $4,10,066.66