Question

A joint venture consortium is formed today (on date 0) as a stand-alone company. The company will be liquidated after one year (on date 1) with expected financials on date 1 as shown below:

                        Revenue                                  $ 800 Million

                        Cost of Goods                         ($ 500) Million

                        Depreciation                           ($ 100) Million

                                                                        ____________

                  Operating Income                   $ 200 million

Tax rate is 40%. Cost of unlevered equity is 15%.

1. Find the value of equity today in an unlevered company.
2. Find the value of levered equity today, in presence of $ 100 million of debt @ 10%.

Answer 1

Sol a.> Operating Income: $ 200m

Tax Rate: 40%

Cost of Unlevered Equity: 15%

Hence, Value of equity today in an Unlevered company = Operating Income*(1-Tax Rate)/Cost of Unlevered Equity

= 200*(1-0.4)/ 15%

= $800m

Sol b.> Levered Equity = Value of an Unlevered firm + Value of debt in a firm’s capital structure*Corporate tax rate

= $800m + $100m* 0.4

= $840m