The market value of Firm L's debt is $200,000 and its cost of debt is 7%. The firm's equity has a market value of $400,000, its earnings are growing at a 4% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Use the APV model to calculate the value of Firm L if it had no debt.

Question

Jeremiah

Business

14 November, 08:31

The market value of Firm L's debt is $200,000 and its cost of debt is 7%. The firm's equity has a market value of $400,000, its earnings are growing at a 4% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Use the APV model to calculate the value of Firm L if it had no debt.

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Joey · Answer 1

Answer: $530000

Explanation:

Debt $200000.

Equity $400000

rd=7%.

rd for equity = 12%

Taxrate = 40%

Earning rate for equity = 4%

Firm L has a total of $200000 + $400000 = $600000

A similar firm with no debt should have a smaller value.

The calculation is as follows.

VTotal = Vu + Vts

Make Vu the subject of the formula

So,

Vu = VTotal - Vts

= Debt + Equity (S) - Vts

Firstly, we need to calculate Vts

Value tax shelter (Vts)

=rdTD (rsU-G)

= 0.07 (0.40) (200000) / (0.12-0.04)

=5600/0.08

= $80,000

Therefore,

Vu = $200000 + $400000 - $70000

Vu = $600000 - $70000

Vu = $ 530000

In conclusion

The value of Firm L if it has no debt is $530000