Backyard Utility is expected to have an EBIT of $250,000 and is an all-equity firm. EBIT is expected to grow at 5% per year. In order to get this growth rate, Backyard needs to retain 40% of earnings for investment. The remaining will be paid out as dividends. The firm's corporate tax rate is 20%. The discount rate for the firm is 10%.
(a) What is the market value of the firm?
(b) Now assume the firm issues $1 million of debt paying interest of 4% per year, using the proceeds to retire equity. The debt is expected to be permanent. What is the equity value of the firm after refinancing?
(c) What is the required return on equity after refinancing?
(d) Assume the growth rate of net income is the same as 5% after refinancing. Backyard now only retains 23.81% of its earnings for investment. Compute the equity value by discounting all the future dividends as in (a). (Hint: you should get the same result as in (b))
(e) If Backyard's manager only wants its total equity value to be $1.8 million instead, how much debt should Backyard actually use?