Dell Gaming Inc. is unlevered and expects its EBIT to be $150 million every year forever. The cost of equity for Dell is 9%, and its tax rate is 25%. The firm can currently borrow long-term debt at a 5% interest rate. Under consideration is issuing $500 million in new debt, and the proceeds of the debt issuance would be used to immediately repurchase $500 million of stock.

Rules:

Ignore any financial distress costs for purposes of answering parts 1 and 2 to this question and assume that the firm has enough taxable income that the firm will always be able to use the interest tax shield - in other words, the debt will be outstanding FOREVER.

Use Modigliani and Miller (MM) propositions I and II with corporate taxes and the related formulas to answer 1. and 2.

Questions:

2. What is the value of the unlevered firm before the recap? (2 points)
4. What is the value of the firm if it borrows $50 million and repurchases shares? (2 points)
6. . If you were to also consider potential financial distress costs from borrowing, would you expect the value in part 2 to be higher or lower than your estimate in 2? Briefly explain your answer. (2 points)

Answer rating: 100% (QA)

Value of the unleveled firm before the recap The value of an unleveled firm Vu is determined by its ... View the full answer