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Gomez tax shield, value of equity; Trumbull value of debt and yield

1. Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

According to the MM extension with growth, what is the value of Gomez's tax shield?

According to the MM extension with growth, what is Gomez's unlevered value?

According to the MM extension with growth, what is Gomez's value of equity?

2. Trumbull, Inc., has total value (debt plus equity) of $500 million and $200 million face value of 1-year zero coupon debt. The volatility (σ) of Trumbull's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

What is the value (in millions) of Trumbull's equity if it is viewed as an option?

What is the value (in millions) of Trumbull's debt if its equity is viewed as an option?

What is the yield on Trumbull's debt?

Solution Preview

1. a) Value of Tax Shield = T*D*rd/(reu-g)
g=growth rate =8%
T=tax rate = 40%
D=debt = $300,000
rd=interest rate on debt = 8%
reu=return on unlevered equity =11%
Please note in case of MM with growth the discount rate on tax shield is higher as reu isntead of rd as in case of MM.
Value of Tax Shield = 40%*300000*8%/(11%-6%)=192,000

b) Value of unlevered ...

Solution Summary

The solution examines Gomez tax shield, unlevered value and value of equity.

$2.19