Question: Could you please explain why the answer for c) is 6million instead of 6.8million?

The market value of a firm with $2,000,000 in debt is $6,800,000. The pre-tax cost of debt for this firm

equals 9% (EAR). If the firm were 100% equity financed, the cost of (unlevered) equity would be 14%

(EAR). (Assume that both the firm's cash flows and the debt are perpetual.) Corporate taxes are 40% and

interest expenses are tax deductible, while dividends are not. Assume that the agency and bankruptcy costs

of debt are zero.

What would be the value of the firm if it were financed entirely with equity?

Answer

VL = VU + TC D =>> VU = VL - TC D = $6,800,000 - 0.4 $2,000,000 = $6,000,000

b) Calculate the WACC for the levered firm.

Answer

REL = REU + [REU - RD] (D/E) (1 - TC) = 14% + (14% - 9%) (2/4.8) 0.6 = 15.25%.

WACC = (E/V) RE + (D/V) RD (1 - TC) = 15.25% 4.8/6.8 + 9% 0.6 2/6.8 = 12.35%.

c) How would your answer to a) change if interest expenses were NOT tax deductible?

Answer

The value of the company would be $6,000,000.