Suppose the corporate tax rate is 21 %. Consider a firm that earns $1,500 before interest...

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Suppose the corporate tax rate is 21 %. Consider a firm that earns $1,500 before interest...

Suppose the corporate tax rate is 21 %. Consider a firm that earns $1,500 before interest and taxes each year with no risk. The firm's capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 7 %.

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?

b. Suppose instead the firm makes interest payments of $ 600 per year. What is the value of equity? What is the value of debt?

c. What is the difference between the total value of the firm with leverage and without leverage?

d. The difference in (c) is equal to what percentage of the value of the debt?

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Answer 1

Answer #1

Value of Equity and Debt:

"Value of Equity" is the value calculated by multiplying the current stock with the outstanding common shares of the company and" Value of debt" is the value the bank debt that the firm has but they are not showing in the firm's balance sheet.

Answer and Explanation:-

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?

The value of the firm's equity is calculated below:

Net Income before interest and tax = $1,500

Net Income after Tax = $1,500*(1 -0.21) = $1185

Net Income as a divided paid each year is $ 1185

Value of Firm's Equity = $ 1185/7% = $16928.57

The value of the firm's equity is $16928.57

b) Suppose instead the firm makes interest payments of $ 600 per year. What is the value of equity? What is the value of debt?

Net Income before interest and tax = $1,500

Net Income = ($1,500 - $600)*(1 -0.21) = $711

Value of Firm's Equity = $711/7% = $10157.14

Debt holders receive interest of $600 per year

Value of Firm's Debt = $600/7% = $8571.43

c) What is the difference between the total value of the firm with leverage and without leverage?

With leverage =$10157+$8571.43=$18728.57

without leverage = $16928.57

Difference = $18728.57-$16928.57=$1800.00

d)The difference in (c) is equal to what percentage of the value of the debt?

The percentage of the value of the debt = $1800/ $8571.43*100 = 20.9999%=21%

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