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Suppose the corporate tax rate is 40 %. Consider a firm that earns $ 4 comma 000 in earnings before interest and

taxes each year with no risk. The​ firm's capital expenditures equal its depreciation expenses each​ year, and it will have no changes to its net working capital. The​ risk-free interest rate is 5 %.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the​ firm's equity?

b. Suppose instead the firm makes interest payments of $ 2 comma 200 per year. What is the value of​ equity? What is the value of​ debt?

c. What is the difference between the total value of the firm with leverage and without​ leverage?

d. To what percentage of the value of the debt is the difference in part ​(c​) ​equal?

Top Answer

a). Net Income = EBIT x (1 - t) = $4000 x (1 - 0.40) = $2400 Hence , Equity Holders receive dividends of $2400per year with... View the full answer

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