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

1. Calculate the unlevered value of the firm:

Unlevered Value = Number of Shares x Market Price per Share
Unlevered Value = 130,000 x $36
Unlevered Value = $4,680,000

2. Calculate the value of the debt:

Value of Debt = $1.5 million

3. Calculate the value of the levered firm:

Value of Levered Firm = Unlevered Value + Value of Debt
Value of Levered Firm = $4,680,000 + $1,500,000
Value of Levered Firm = $6,180,000

4. Calculate the cost of equity after the addition of debt:

Cost of Equity = Cost of Capital - [(Cost of Capital - Cost of Debt) x (1 - Tax Rate)]
Cost of Equity = 14% - [(14% - 7%) x (1 - 0.35)]
Cost of Equity = 11.55%

5. Calculate the levered value of equity:

Levered Value of Equity = Value of Levered Firm - Value of Debt
Levered Value of Equity = $6,180,000 - $1,500,000
Levered Value of Equity = $4,680,000 x 0.885 (1 / 1.12345)
Levered Value of Equity = $4,146,120

Therefore, the levered value of equity is $3.705 million (Option C).

Hanover Tech Is Currently an All Equity ﬁRm That Has