Question
Libby Co. is an unlevered firm. Investors currently expect a 11.55% return on the companys equity. The company is subject to a 20% corporate tax
Libby Co. is an unlevered firm. Investors currently expect a 11.55% return on the companys equity. The company is subject to a 20% corporate tax rate. If earnings before taxes are expected to be $89.85m per year forever, calculate the total value of this company. Now suppose this company wants to shift its capital structure to add debt. It wants to issue $120 million of perpetual debt at an interest rate of 7.2%. Use the FTE method to calculate the value of the companys equity after the recapitalization. What is the total value of the company after the recapitalization? Using MMII with taxes, what should be the total value of the company after issuing the debt? What is the debt-equity ratio of this company after the recapitalization? Suppose the levered company is looking to invest in a new project. The project costs $37 million and will be financed at the debt-equity ratio you calculated in e. The project generates EBIT of $6.9 million in perpetuity. Would you advise Libby to invest in this project? (Hint: use the FTE methodbe sure to show how much borrowing you will do and what annual interest costs will be).
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