What is the value of the unlevered firm

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Please show all formulas and calculations.

1. Suppose the world is perfect except that firms have to pay corporate taxes. A firm with no debt has earnings before interest and taxes (EBIT) of $60,000. The firm expects to keep earning the same EBIT in all future years. The firm's cost of capital is 14%. Assume there is no depreciation, capital expenditures, or net working capital. The corporate tax rate is 30%.

A levered firm with the same operations and assets has $100,000 of debt. The firm expects to keep its debt at the same level in all future years. The interest rate of the outstanding debt and the cost of debt are both assumed to be 8% in all future years. The corporate tax rate is also 30%.

a) What is the value of the unlevered firm?

b) What is the value of the levered firm?

2. How would a firm's optimal debt-equity ratio change (if at all) if its (marginal) tax rate went down? Please explain your answer.

Reference no: EM132199188

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