Sun plc expects its EBIT to be £200,000 every year forever. It currently has no debt but can borrow at a rate of 10 per cent. The firm’s WACC is currently 15 per cent and the tax rate is 25 per cent.

1. What is the value of the firm and its cost of equity?                                          (3 Marks)
2. What would be the value of the firm and its cost of equity if it borrows 300,000 and uses the proceeds to repurchase shares?                                                               (4 Marks)
3. Comment on the values you have calculated in parts (a) and (b).                     (3 Marks)

Answer (a):

As mentioned in the question that currently firm has no debt. Therefore at present firm is having only equity and therefore we need to find out the value of unlevered firm.

Value of Unlevered firm = EBIT * (1-t) / WACC

where,

EBIT = 200000

t = tax rate = 25%

WACC = 15%

Therefore Value of Unlevered firm = 200000 * (1-25%) / 15%

= 200000 * 5

= 1000000

Value of the firm = £1000000

Calculation of Cost of Equity:

As the firm has only equity therefore WACC i.e. 15% is its Cost of Equity.

Answer (b):

If the firm borrows 300000 then we needs to find the value of levered firm:

Value of Levered Firm = Value of Unlevered firm + Debt * Tax rate

= 1000000 + (300000*25%)

= 1075000

Calculation of Cost of Equity:

Cost of equity (ke) = WACC + (WACC - Cost of debt) * (Debt / Equity) * (1-tax)

WACC = 15%

Cost of debt = 10%

Debt = 300000

Equity = 1075000 - 300000 = 775000

Tax rate = 25%

Therefore cost of equity = 15% + (15%-10%) * (300000/775000) * (1-25%)

= 15% + 1.45%

= 16.45%

Answer (c):

In case of Value of Firm, The value has been increased from 1000000 to 1075000 because the firm will get tax advantage due to debt

In case of cost of equity cost has been increased from 15% to 16.45% because due to issue of debt risk of shareholders has increased.