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capital structure

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Gibson Inc. expects perpetual earnings before interest and taxes of $1.2
million per year. The firmâ??s pretax cost of debt is 8 percent per annum, and its annual interest expense is $200,000. Company analysts estimate that the unlevered cost of Gibsonâ??s equity is 12 percent. Gibson is subject to a 35 percent corporate tax rate.

a. What is the value of this firm?
b. If there are no costs of financial distress or bankruptcy, what percentage of
the firmâ??s capital structure would be financed by debt?
c. Is the conclusion in (b) applicable to the real world?

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Solution Summary

The capital structure of a firm is assessed.

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a. Since Gibson has debt, we have to calculate the value of the firm as levered value.
For a levered firm
Value of firm = Value of unlevered firm + debt tax shield
Value of unlevered firm = EBIT X (1-tax rate)/unlevered cost of ...

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