An unlevered firm has a cost of equity of 20% and is considering taking debt of Kshs. 200,000 at a cost of 10%. The firm’s earnings before interest and tax are Kshs. 153,850 and the corporate tax is 35%. Calculate the value of the firm before and after taking debt.

Question two

XYZ expects a net operating income of 2 million in the coming year. Its capital structure is 40% debt and 60% equity and the marginal tax rate is 40%. Shareholders require 14% of their return. The company will pay 10% on its 5 million long term debt. It has an outstanding total shareholding of 1 million. In the next capital budgeting cycle, the firm expects to fund a positive NPV project costing 1.2 million according to its current capital structure. All the earnings after financing the projects are paid out as dividends (residual policy) Required:

a) value of debt

b) value of equity

c) MPS

d) dividend payout ratio

Question three

Salt and Milk are identical in every way except that Milk has 25% debt at risk-free rate of 9%. The cost of equity of Salt is 12%. Calculate the WACC of both firms’ assuming a corporate tax of 35% for each firm