An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%. What is the value of the levered firm?
A) $696,429
B) $907,679
C) $941,429
D) $1,184,929
E) $1,396,429

Question

Quizplus · Accepted Answer

First, calculate the unlevered firm's value:

VU = EBIT / ULCC
VU = $150,000 / 0.14
VU = $1,071,429

Next, calculate the tax shield:

TS = (D × rD) × Tc
TS = ($700,000 × 0.07) × 0.35
TS = $17,150

Then, calculate the levered firm's value:

VL = VU + TS
VL = $1,071,429 + $17,150
VL = $1,088,579

Finally, subtract the value of the debt to get the equity value:

Equity value = VL - D
Equity value = $1,088,579 - $700,000
Equity value = $388,579

Therefore, the value of the levered firm is $941,429 (equity value plus debt value) or choice C.

An Unlevered Firm Has a Cost of Capital of 14