You are thinking of starting a firm that manufactures electronic medical devices. The required capital investment in plant and equipment is $20,000,000.00. After your manufacturing facility is completed, the firm will generate an average return on investment before interest and taxes of 15 percent each year. However, the earnings before interest and taxes is risky and will vary from year to year depending upon economic conditions in the medical equipment industry. For present value calculations, assume that the EBIT is realized at the end of each year starting with the first cash flow being received at the end of t =0 (i.e., at t = 1). The risk-free rate is .035. The stakeholders of the firm have personal tax rates TS = TB = .15. The corporate tax rate is .28. You have looked at other electronic medical device manufactures that have similar products and assets. MedEDev Inc, in particular, is very similar to your proposed firm. Below is the data on MedEDev Inc.
Value of Debt: $20,000,000
Value of Equity: $10,000,000
Shareholders personal tax rates:
Dividend and Capital Gains Rate: .15
Interest Income: .15
Corporate Tax Rate: .28
Expected Return on Equity: .12
Yield on Debt: .065
Expected Return on the Market: .20
If you fund your firm by issuing only equity, what is a good estimate of the required rate of return on the firm’s equity in the unlevered firm?
What will be the value of your unlevered firm?
If you fund your firm solely with equity, should you go forward with your idea? Why or why not?