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. Assuming this as the optimum capital structure, the value of the firm is ________.
A) $1.4 million
B) $2.2 million
C) $1.8 million
D) $6.0 million

Question

Quizplus · Accepted Answer

First, we need to calculate the weighted average cost of capital (WACC) using the target capital structure:

WACC = (0.4 x 0.05) + (0.6 x 0.15) = 0.09 or 9%

Next, we can use the constant growth model to value the firm:

V = (Operating profit - Interest) x (1 - Tax rate) / (WACC - g)

Where g is the expected growth rate. Since no growth rate is given, we can assume a reasonable long-term growth rate of 3%.

V = ($300,000 - $35,000) x (1 - 0.4) / (0.09 - 0.03) = $1,800,000

Therefore, the value of the firm is $1.8 million.

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