XYZ Limited is considering purchasing a widget maker. The widget maker will result in EBIT of $50,000 per year for 20 years. The widget maker will be depreciated over a 20 year period using straight-line method, and will have no salvage value. The widget maker will not add/reduce the risk of the firm. XYZ has cost of unlevered equity of 12%, and pays corporate tax at 40%. Risk free rate of return is 3%.

a. What is the maximum price XYZ should pay for the widget maker?

b. Suppose due to economic reasons provincial government is willing to lend XYZ $120,000 at 2% for 20 years. Only interest will be paid each year. Principal will be paid at the end of the 20th year. Using APV approach, what is the maximum price XYZ would be willing to pay for the widget maker if XYZ's cost of debt is 8%?

QUESTION 5:

LonglastTechnologies Limited (LTL) an all equity firm has current EBIT of $1,000,000. It expects EBIT to increase at 5% per year forever. The corporate tax rate is 40%, and cost of unlevered equity is 12%.

LTL is considering replacing some of the equity with perpetual debt. It has been determined that risk of bankruptcy is a function of amount of debt. PV of bankruptcy related costs will be $5,000,000. LTL is considering the following debt levels.

Debt $3,000,000 $6,000,000 $9,000,000

Probability of Bankruptcy 0.10 0.30 0.60

a. Determine the optimal level of debt, and the value of the firm at that level.

b. If personal tax rate on stock income is 25%, and the personal tax rate on bond income is 43% at what debt level value of the firm be optimal