Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
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Chapter 21, Problem 3P
Summary Introduction
To calculate: The value of the levered firm using compressed adjusted present value model.
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An unlevered firm has a value of $850 million. An otherwise identical but levered firm has $80 million in debt at a 3% interest rate, which is its pre-tax cost of debt. Its unlevered cost of equity is 10%. After Year 1, free cash flows and tax savings are expected to grow at a constant rate of 4%. 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.) Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places.
Suppose a firm’s tax rate is 25%.
1. What effect would a $9.26 million operating expense have on this year's earnings? What effect would it have on next year's earnings? (Select all the choices thatapply.)
A. A $9.26 million operating expense would be immediately expensed, increasing operating expenses by $9.26 million. This would lead to a reduction in taxes of 25%×$9.26 million=$2.32 million.
B. A $9.26 million operating expense would be immediately expensed, increasing operating expenses by $9.26 million. This would lead to an increase in taxes of 25%×$9.26 million =$2.32 million.
C. Earnings would decline by $9.26 million−$2.32 million=$6.94 million. The same effect would be seen on next year's earnings.
D. Earnings would decline by $9.26 million−$2.32 million=$6.94 million. There would be no effect on next year's earnings.
2. What effect would a $11.75 million capital expense have on this year's earnings if the capital expenditure is depreciated at a rate of $2.35 million…
Grommit Engineering expects to have net income next year of $24.36 million and free cash flow of $22.17
million. Grommit's marginal corporate tax rate is 35%.
a. If Grommit increases leverage so that its interest expense rises by $6.7 million, how will net income
change?
b. For the same increase in interest expense, how will free cash flow change?
a. If Grommit increases leverage so that its interest expense rises by $6.7 million, how will net income
change?
Net income will fall to $ 4.36 million. (Round to two decimal places.)
b. For the same increase in interest expense, how will free cash flow change? (Select the best choice
below.)
A. Free cash flow increases by the amount of the interest expense.
B. Free cash flow decreases by the amount of the interest expense.
C. Free cash flow is not affected by interest expense.
D. None of the above.
Chapter 21 Solutions
Financial Management: Theory & Practice
Ch. 21 - Prob. 1QCh. 21 - Modigliani and Miller assumed that firms do not...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 - Prob. 3PCh. 21 - Prob. 4PCh. 21 - A company’s most recent free cash flow to equity...Ch. 21 - Air Tampa has just been incorporated, and its...Ch. 21 - Companies U and L are identical in every respect...Ch. 21 - Schwarzentraub Corporation’s expected free cash...
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