Suppose the Kumar Corpora

Suppose the Kumar Corpora

Suppose the Kumar Corporation has no debt and is asking whether issuance of debt canincrease the company’s value. The firm has annual earnings before interest and taxes of$8,000,000. Their proposal is to borrow $6,000,000 in the form of perpetual debt (i.e., debtthat never matures). The company’s management decides that the cost of equity for thecompany is 12%. Kumar is planning to buy back its stock with the entire amount borrowed.The company’s tax bracket is 35%.(a) Compute the company’s value if they borrow.(b) You know the company’s nancial data and conclude that they made a mistake whilecomputing the cost of equity. You estimate the correct beta for unlevered rm to be 1.2.Assume the risk-free interest rate is 7% and the market risk premium is 5%, Re-calculatethe value of the company with borrowing.

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