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Consider a firm that is currently all-equity financed. The firm produces a perpetual EBIT of $100m per annum and has an all-equity cost of capital

Consider a firm that is currently all-equity financed. The firm produces a perpetual EBIT of $100m per annum and has an all-equity cost of capital (required return on equity) of 10 per cent. The corporate tax rate is 30 per cent, and the interest rate on debt is 3 per cent. The company is to be acquired under a LBO, under which an initial level of debt of $500m will be taken on, with repayment of $100m per year and interest on the principal at the end of each of years 1, 2, and 3. A level of debt of $200m will then be maintained in perpetuity.

a. Calculate the present value of interest tax shield, you may assume that you can discount any debt-related cash flows at the cost of debt.

b. Calculate the value of the firm before LBO

c. Calculate the value of the firm following LBO using the APV method

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