Reading 26 Practice Problem 17

CFA Level II Corporate Finance
#1

Hello. Can you please help explain the practice problem 17 on Reading 26 of CFAI curriculum book?

The problem describes a company that issues $1 million in debt in order to buy back an equivalent amount of equity. The company currently has all-equity financing and EBIT=400,000 and tax rate is 30%. And the current WACC (100% equity) is 10%.

The market value of equity = (EBIT*(1-0.3))/(10%) = 2,800,000.

Then, I thought, after the issuance of debt, the equity decreases to 1,800,000 and debt becomes 1,000,000. The total doesn’t chance. But, the solution says that Value of the Company = 2,800,000 + 1,000,000*(tax rate) = 3,100,000. I don’t understand why the share buy-back doesn’t reduce the market value of equity…

Please help… Thanks…

#2

this is a tricky q i remember.Wit i will also solve it and tell u

#3

we need to calculatre value of unlevered firm = EBIT(1-T)/ R0

Then Value of levered firm= Vu+ TD

Then take out as Debt as % of total .

Then D/E

Then apply formula to calculate Re