Houston Tools has expected earnings before interest and taxes of $189,400,an unlevered cost of capital of 12.87 percent,and a tax rate of 34 percent.The company has $318,000 of debt that carries a coupon rate of 6.2 percent.The debt is selling at par value.What is the value of this firm?
A)$996,758.89
B)$1,079,402.05
C)$978,758.89
D)$1,113,758.89
E)$1,036,758.89

Question

Quizplus · Accepted Answer

Step 1: Calculate the WACC
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
where
Re = Unlevered cost of capital = 12.87%
Rd = Cost of debt = Coupon rate = 6.2%
Tc = Tax rate = 34%
E = Value of equity
D = Value of debt
V = Total value of the firm = E + D

We are given
Unlevered cost of capital = 12.87%
Tax rate = 34%
Coupon rate = 6.2%
Value of debt = $318,000
Value of equity = ?
Total value of the firm = ?

First, let's calculate the cost of equity using the unlevered cost of capital and the tax rate.
Re = Unlevered cost of capital x (1 + (1 - Tax rate) x (D/E))
where
D/E = Debt/Equity
D/E = $318,000 / E

Re = 12.87% x (1 + (1 - 34%) x ($318,000 / E))
Re = 17.12%

Next, let's calculate the total value of the firm.
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
WACC = (E / (E + $318,000) x 17.12%) + ($318,000 / (E + $318,000) x 6.2% x (1 - 34%))
WACC = 12.87%

12.87% = (E / (E + $318,000) x 17.12%) + ($318,000 / (E + $318,000) x 6.2% x (1 - 34%))

Solving this equation, we get
E = $1,079,402.05

Finally, the value of the firm is
V = E + D
V = $1,079,402.05 + $318,000
V = $1,397,402.05

Therefore, the value of the firm is $1,079,402.05 (Option B).

Houston Tools Has Expected Earnings Before Interest and Taxes of $189,400,an