Consider the same two firms U and L - that are identical except for capital structure. Each firm expects EBIT of $650,000 each year forever. Firm U has a cost of equity of 10% and Firm L has $2 million in perpetual debt with a coupon rate of 7%. There is no chance of bankruptcy, but earnings of each are taxed at a rate of 45%.

 

Part 1- What is the value of firm U?

Part 2- What is the value of equity for Firm U?

Part3- What is the value of equity for Firm L?

Part4- What is the value of Firm L?

Part 1- What is the value of firm U?

Answer - $6,500,000

Part 2- What is the value of equity for Firm U?

Answer - $6,500,000

Part3- What is the value of equity for Firm L?

Answer - Nil

Part4- What is the value of Firm L?

Answer - $7,276,265

Step-by-step explanation

FIRM U

EBIT = $650,000 each year forever.

Cost of equity of 10%

Tax Rate = 45%.

Value of Firm = EBIT / (R_eu) 

Where,

R_eu = Required Rate of Return for unlevered firm i.e. 10%

So, Value of Firm = $650,000 / 10%

= $6,500,000

Value of Equity= $65,00,000

(Since there is no debt in Firm U, so Value of equity will be equal to the Value of Firm)

FIRM L

EBIT = $650,000 each year forever.

Debt = $2,000,000

Coupon Rate = 7%

Interest Expense = $140,000

Tax Rate = 45%.

Kd i.e. Cost of Debt = 7% * 55% = 3.85%

Value of Firm = Market Value of Equity + Market Value of Debt

= 0 + Market Value of Debt

EBIT = $650,000

Interest Expense = $140,000

Profit Before Taxable = $510,000

Tax = $229,500

Profit after Tax (Cashflow) = $280,500

So,

Value of Firm = $280,500 / 3.85%

= $ 72,76,265