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Determine the value of the firm before the debt-equity swap

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Raymond Manufacturing is a privately held company; all long-term finances are from the Raymond brothers in the form of equity interests. An aggregate of 1 million shares is distributed between the Raymond brothers: Roy has a 50% equity interest in the firm and Bon has the other 50% equity interest.
The firm is expected to generate annual earnings stream (EBIT) in the amount of $3.692 million per annum in perpetuity. The estimated beta for the company is 1.923 (?0). The firm pays a 35% corporate tax rate.

The firm intends to conduct a debt-equity swap by raising 4.731 million in debt and using the proceeds to retire a portion of the existing equity interest held by the brothers. This additional borrowing is in the form of a syndicated loan from a group of commercial banks. The effective interest rate on this syndicated loan (rb) is 10% per annum. For ease of calculation, we shall assume a perpetual loan. That is, we assume the firm can indefinitely restructure this loan at the same market interest rate of 10% per annum.

Supplemental data: rf = 5% and E(rm) = 18%

Question: Determine the value of the firm before the debt-equity swap

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Solution Summary

This solution carefully determines the value of the firm before the debt-equity swap.

$2.19