Question

Cavo Corporation expects an EBIT of $21,000 every year forever. The company currently has no debt, and its cost of equity is 12 percent. The corporate tax rate is 35 percent.

  

a.	What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Company value

$

  

b-1.	Suppose the company can borrow at 10 percent. What will the value of the company be if it takes on debt equal to 50 percent of its unlevered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Company value

$

  

b-2.	Suppose the company can borrow at 10 percent. What will the value of the company be if it takes on debt equal to 100 percent of its unlevered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Company value

$

  

c-1.	What will the value of the company be if it takes on debt equal to 50 percent of its levered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Company value

$

  

c-2.	What will the value of the company be if it takes on debt equal to 100 percent of its levered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Company value

$

Answer 1

Answer a.

Vale of Unlevered Firm = EBIT * (1 - Tax) / Cost of Equity
Vale of Unlevered Firm = $21,000 * (1 - 0.35) / 0.12
Vale of Unlevered Firm = $113,750

Answer b-1.

Value of Debt = 50% * Vale of Unlevered Firm
Value of Debt = 50% * $113,750
Value of Debt = $56,875

Value of Levered Firm = Vale of Unlevered Firm + Tax * Value of Debt
Value of Levered Firm = $113,750 + 0.35 * $56,875
Value of Levered Firm = $133,656.25

Answer b-2.

Value of Debt = 100% * Vale of Unlevered Firm
Value of Debt = 100% * $113,750
Value of Debt = $113,750

Value of Levered Firm = Vale of Unlevered Firm + Tax * Value of Debt
Value of Levered Firm = $113,750 + 0.35 * $113,750
Value of Levered Firm = $153,562.50

Answer c-1.

Value of Debt = 50% * Vale of Levered Firm

Value of Levered Firm = Vale of Unlevered Firm + Tax * Value of Debt
Value of Levered Firm = $113,750 + 0.35 * 50% * Value of Levered Firm
Value of Levered Firm = $113,750 + 0.1750 * Value of Levered Firm
0.8250 * Value of Levered Firm = $113,750
Value of Levered Firm = $137,878.79

Answer c-2.

Value of Debt = 100% * Vale of Levered Firm

Value of Levered Firm = Vale of Unlevered Firm + Tax * Value of Debt
Value of Levered Firm = $113,750 + 0.35 * 100% * Value of Levered Firm
Value of Levered Firm = $113,750 + 0.35 * Value of Levered Firm
0.65 * Value of Levered Firm = $113,750
Value of Levered Firm = $175,000