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4 June, 01:46

An unlevered firm has a cost of capital of 13.6 percent and earnings before interest and taxes of $138,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $520,000 with an annual coupon of 7 percent. The applicable tax rate is 34 percent. What is the value of the levered firm

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  1. 4 June, 02:13
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    Value of levered firm is $846,506

    Explanation:

    The value of levered firm will be the sum of value of the future incomes for the shareholder's at the cost of capital of un-levered firm discounted at cost of equity and the tax advantage of debt.

    The value of equity = Profit before tax * (1 - Tax) / Cost of capital

    The tax advantage = Value of debt * tax rate

    Now putting the values in both above equation:

    Value of equity = $138,000 (1 - 34%) / 13% = $6,69,706

    The tax advantage of Debt = $520,000 * 34% = $176,800

    Value of levered firm = $669,706 + $176,800 = $846,506
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