Question

maetsro frozen foods expects to earn 365000 in perpetuity before interest and taxes from its line of gourment tv dinners. the company has a debt to assets ratio of 40%. the cost of debt is 10%. if the company had no debt, its cost of capital would have been 15%. the firms tax rate is 30. what is the value of the firm? the value of its equity?The required rate of return on equity?the weighted average cost of capital?

Answer 1

If no debt, only equity then cost of capital is 15%

So, required Return on equity is 15%

Cost of debt = 10%

After tax cost of debt = Before tax cost*(1-tax rate)

10%*(1-40%)

6.00%

Debt to asset ratio is 40%. So debt = 0.40 and equity weight is 1-0.40 = 0.60

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

(0.40*6%)+(0.60*15%)

11.40%

Value of firm = EBiT*(1-tax rate)/WACC

365000*(1-40%)/11.40%

219000 /0.114

1921052.632

Value of firm is $1,921,052.63

Value of equity = Value of firm*Equity weight

1921052.63*60%

= $1152631.579

So, value of equity is $1,152,631.58

WACC is 11.40% and Return on Equity is 15%