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Cogswell Cogs (CC) is a fast-growing firm with expected earnings of $4.2 million next year. CC...

Cogswell Cogs (CC) is a fast-growing firm with expected earnings of $4.2 million next year. CC expects earnings to grow 12% per year indefinitely and CC’s cost of capital is 14%. CC has creative accounts, so it pays no taxes. What is the market value of CC? If CC has no debt, then what is its P0/E1 ratio? If CC repurchases $40 million in equity using $40 million in debt with an interest rate of 8% (cost of capital (WACC) remains 14%), what is the new P/E ratio?

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Expert Solution

CC Company Valuation details Nos in Millions
Expected earning next year =P0                              4.20
Earning Growth rate =g= 12% pa
Cost of Capital=k 14%
Market Value of CC=P0*(1+g)/(k-g)=4.2*(1+12%)/(14%-12%)=                          235.20
So Market Value of CC=$235.2 Million
As it has no debt , the value of Equity= $235.2 Million
Earning for Equity shareholders =$4.2M
So P0/E1=235.2/4.2=56
When CC repurchased $40M shares with $40M debt @ 8% interest pa,
In this case EBIT remains unchanged , so Market value remains unchanged.
The Market Value of Equity becomes=$235.2M-$40M=$195.2Million
Interest per year on $40M loan =$40M*8%=$3.2M
Earnings for Equity shareholders =$4.2M-$3.2M=$1M
so New P/E ratio= 195.2/1=195.2

jeff jeffy answered 2 years ago
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