question archive The Philly Cheese Corporation is a firm financed with $200M perpetual debt and $290M of equity
The Philly Cheese Corporation is a firm financed with $200M perpetual debt and $290M of equity
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The Philly Cheese Corporation is a firm financed with $200M perpetual debt and $290M of equity. The expected return on the debt is 5%. Firms in the same industry that are all-equity financed have an expected return of 10%. The corporate tax rate is 42%. Assume that Philly Cheese has only one current project which generates perpetual annual earnings before taxes and interest of X.
(a) What is X?
(b) What is the current expected return on the equity of the firm?
(c) What is the weighted average cost of capital of the firm?
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Answer:
VALUE OF LEVERED FIRM = VALUE OF DEBT + VALUE OF EQUITY
VALUE OF LEVERED FIRM = 200 + 290 =490
VALUE OF LEVERED FIRM = VALUE OF UNLEVERED FIRM + DEBT (TAX RATE)
490 = VALUE OF UNLEVERED FIRM + 200 (42%)
490 =VALUE OF UNLEVERED FIRM + 84
VALUE OF UNLEVERED FIRM = 406
RETURN ON EQUITY = (EBIT(1-t)/VALUE OF UNLEVERED FIRM) * 100
10% = (EBIT (1-0.42) /406 )* 100
EBIT = 70
(a) X = EBIT =70
(b) EXPECTED RETURN ON THE EQUITY OF THE FIRM = [(EBIT - I) (1-t) / EQUITY]*100
= [(70 - 10)*(1-0.42)/ 290[*100 = 12%
(c ) WACC =(We)*(Ke) + (Wd)*(Kd)*(1-t)
WACC = (290/490)*(12%) + (200/490)(5%)(1-0.42)
WACC = 7.1020 + 1.1837 = 8.2857%
