Question

Trade-off Theory. Smoke and Mirrors currently has EBIT of $25,000 and is all-equity financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 35 percent of taxable income. The discount rate for the firm"s projects is 10 percent.
a. What is the market value of the firm?
b. Now assume the firm issues $50,000 of debt paying interest of 6 percent per year and uses the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?

Answer 1

Answer:

A. $162,500

B. $17,500

Explanation:

Data

EBIT = $25,000

Tax rate = T = 35%

Discount Rate = r = 10%

Requirement A:  Market Value

The Market value of the firm can be calculated by using the following formula

Market Value =  $\frac{EBIT(1-T)}{r}$

Market Value = $\frac{25000(1-0.35)}{0.1}$

Market Value = $162,500

Requirement B: Total value of firm If issues $50,000 of debt paying 6% interest

The market value of the firm increases by the present value of the Interest tax shield

The present value of tax shield = Amount of debt x Tax Rate

The present value of tax shield = $50,000 x 35%

The present value of tax shield = $17,500

The market value of the firm will be increased by $17,500