L. A. Clothing has expected earnings before interest and taxes of $1,900, an unlevered cost of capital of 16 percent and a tax rate of 34 percent. The company also has $2,600 of debt that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm

$8,721.5

Explanation:

As per the question details provided, we are required to calculate the value of levered firm. Difference between the levered and unlevered firm is that the levered firm compromises of both the equity and debt in its valuation while the unlevered firm only has equity and no debt.

Therefore, the value of levered firm is the sum of the value of unlevered firm and the tax shield available to firm as interest expense on the debt which is tax deductible. The calculation is as follows:

Value of Unlevered Firm (VU) = {Expected Earnings x (1 - Tax Rate)} / Cost of capital

VU = [$1,900 x (1 - .34)]/.16 = $7,837.5

Value of Levered Firm (VL) = VU + Tax Rate (Debt Value)

VL = $7,837.5 + .34 ($2,600) = $8,721.5

Hence, value of the firm is $8,721.5

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