A firm has an operating profit of $300,000, interest of $35,000, and a tax rate of 40 percent. The firm has an after-tax cost of debt of 5 percent and a cost of equity of 15 percent. The firm's target capital structure is set at a mix of 40 percent debt and 60 percent equity. According to the traditional approach to capital structure, the value of the firm is
A) $1.4 million.
B) $6.0 million.
C) $2.7 million.
D) $2.0 million.

Question

Quizplus · Accepted Answer

Step 1: Calculate the Weighted Average Cost of Capital (WACC)
Debt proportion = 40%; Equity proportion = 60%
After-tax cost of debt = 5%*(1-40%) = 3%
WACC = (40%*3%) + (60%*15%) = 9%

Step 2: Calculate the firm value using the formula below
Firm Value = Operating Profit / WACC - Interest(1 - tax rate) / WACC
Firm Value = 300,000 / 9% - 35,000(1-40%) / 9%
Firm Value = $2.7 million

Therefore, the best choice is C.

A Firm Has an Operating Profit of $300,000, Interest of $35,000