FINS1613 Question (1 Viewer)

[Carl Gauss]

Anyone know how to do this?

 

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Remember the PV of perpetuity = C/r

(a) (i)

Value is $2.6mill in perpetuity discounted at the required return on equity.

Value of equity = 2.6mill/0.13 = $20million

(ii)

If the firm has $10million of debt, it must pay interest expense of 10million x 9% = 10mill x 0.09 = 0.9million every year.

Therefore the cash flows of the firm will be 2.6mill - 0.9mill = 1.7million in perpetuity. Discount it at the required return of equity.

Value of equity = 1.7mill / 0.13 = 13.07million

Total value of firm = Equity +Debt = 13.07mill + 10mill = 23.07million


(b) (i)

Cash flows are now 2.6million x (1- 0.4) = 1.56million in perpetuity.

Value of equity = 1.56mill /0.13 = 12million

(ii) Remember interest payments can be claimed as a tax deduction.

With $10million of debt, the firm pays 0.9million interest every year.

Net cash flow BEFORE tax = 2.6mill-0.9mill = 1.7mill

Net cash flow AFTER tax = 1.7mill x (1-0.4) = 1.02million

Value of equity = 1.02/0.13 = $7.85million

Value of firm = Equity + Debt = 7.85mill +10mill = 17.85million

Fairly sure it's correct. Better check it with the lecturer

 

[Carl Gauss]

Thank you fortune_cookie

 

[fortune_cookie]

Thank you fortune_cookie

I changed the answer.

I am fairly sure the cash flows only value the equity. Remember the cash flows are paid out 100% as dividends. You need to add the debt to get the whole value of the firm.