Hanover Tech is currently an all equity firm that has 130,000 shares of stock outstanding with a market price of $36 a share. The current cost of equity is 14% and the tax rate is 35%. The firm is considering adding $1.5 million of debt with a coupon rate of 7% to its capital structure. The debt will be sold at par value. What is the levered value of the equity?
A) $3.180m
B) $3.520m
C) $3.705m
D) $4.875m
E) $5.205m

Question

Quizplus · Accepted Answer

The levered value of the equity can be calculated using the Modigliani-Miller Proposition II with taxes. The formula to calculate the levered value of the firm (V_L) is V_U + Tc*D, where V_U is the unlevered value of the firm, Tc is the corporate tax rate, and D is the debt. The unlevered value of the firm (V_U) is the market value of equity, which is 130,000 shares * $36/share = $4.68 million. The tax shield on the debt is Tc*D = 0.35 * $1.5 million = $0.525 million. Therefore, the levered value of the firm is $4.68 million + $0.525 million = $5.205 million. However, the question asks for the levered value of the equity, not the firm. The levered value of the equity is the levered value of the firm minus the debt, which is $5.205 million - $1.5 million = $3.705 million.

Hanover Tech Is Currently an All Equity Firm That Has