An unlevered firm has a value of $800 million. An otherwise identical but levered firm has $60 million in debt at a 5% interest rate

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An unlevered firm has a value of $800 million. An otherwise identical but levered firm has $60 million in debt at a 5% interest rate

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An unlevered firm has a value of $800 million. An otherwise identical but levered firm has $60 million in debt at a 5% interest rate, which is its pre-tax cost of debt. Its unlevered cost of equity is 11%. After Year 1, free cash flows and tax savings are expected to grow at a constant rate of 3%. Assuming the corporate tax rate is 25%, use the compressed adjusted present value model to determine the value of the levered firm.
(Hint: The interest expense at Year 1 is based on the current level of debt.)

Explanation & AnswerSolution by a verified expert

Explanation

Value of unlevered firm=$800m
 
Then tax the debt
Tax benefit(shield)=25%*$60m=$15m
As constant growth is 3%.The benefit=60m*25%*5%*(1+3%)/(5%-3%)=$38.625m
So the value of levered firm=value of unlevered firm+ Debt tax benefit
So the value of levered firm=800m+38.625m=838.625m
Adjusted levered firm's value is 838.625 million

Answer

Adjusted levered firm's value is 838.625 million

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