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Suppose the ABC Corporation is currently all-equity financed and would like to increase its value by issuing debt.
The firm has annual earnings before interest and taxes of $7,000,000. Their proposal is to borrow $4,500,000 in the form of perpetual debt. The company's management decides that the cost of equity for the company is 12%.
ABC 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 financial data and conclude that they made a mistake when computing the cost of equity. You estimate the correct beta for the unlevered firm to be 1.3. Assume the risk-free interest rate is 7% and the market risk premium is 5%, Re-calculate the value of the company with borrowing.
main function of the insurance market
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