Answer:
a) $130,000
b)Equity = $110,500
Value of debt = $30,000
c) $10,500
d) 35%
Step-by-step explanation:
Given:
Tax rate = 35%
Earnings before tax & interests = $10,000
Risk free interest rate = 5.0%
a) Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm’s equity?
First find net income.
Net income = $10,000(1 - 0.35)
= $(10,000 - 0.65)
= $6,500
Since net income is $6,500 it means equity shareholders receive dividends of $6,500 annually without risk.
Therefore,
equity = Net income / risk free rate
= 6500/0.05
= $130,000
Equity = $130,000
b) First find net income:
($10,000 - $1,500)(1 - 0.35)
($8,500)(0.65) = $5,525
Net income = $5,525
Find equity:
Equity = Net income / risk free rate
= $5,525 / 0.05
= $110,500
Equity = $110,500
Value of debt:
Use the formula below to find value of debt:
Debt = Interest / risk free rate
= $1,500 / 0.05
= $30,000
Value of debt = $30,000
c) Find the total value of the firm with leverage:
$110,500 + $30,000
= $140,500
The total value of the firm without leverage: $130,000
Now, the difference between the total value of the firm with leverage and without leverage:
$140,500 - $130,000
= $10,500
Difference = $10,500
d) Find the percentage difference:
% difference = difference/debt * 100
