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) $2.0 million.
C) $2.7 million.
D) $6.0 million.

Question

Quizplus · Accepted Answer

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

WACC = (0.4 x 0.05) + (0.6 x 0.15) = 0.10 or 10%

Next, we can use the traditional approach to calculate the value of the firm:

Value of the Firm = Operating Profit / WACC

Value of the Firm = $300,000 / 0.1 = $3,000,000

To get the value of the equity, we subtract the value of debt from the value of the firm:

Value of Equity = $3,000,000 – (0.4 x $3,000,000 x (1-0.4)) = $3,000,000 – $720,000 = $2,280,000

Therefore, the answer is C, $2.7 million.

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