Question

Cavo Corporation expects an EBIT of $27,000 every year forever. The company currently has no debt, and its cost of equity is 14 percent. The corporate tax rate is 35 percent.

  

a.	What is the current value of the company? (Round your answer to 2 decimal places. (e.g., 32.16))

  

Current value

$

  

b-1	Suppose the company can borrow at 9 percent. What will the value of the firm be if the company takes on debt equal to 40 percent of its unlevered value? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Value of the firm

$

  

b-2	Suppose the company can borrow at 9 percent. What will the value of the firm be if the company takes on debt equal to 100 percent of its unlevered value? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Levered value

$

  

c-1	What will the value of the firm be if the company takes on debt equal to 40 percent of its levered value? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Value of the firm

$

  

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

  

Levered value

$

Answer 1

Ans.

(a)

The unlevered firm value is

EBIT * (1 - tax rate)/ Cost of Equity = $27,000 * (1- 0.35)/0.14 =$ 17,550 / 0.14 = $ 125,357.14

b)

The levered firm value with the debt being 40% of its unlevered value is

The general expression for the value of a leveraged firm is:

V _L = V _U + t _C D

If debt is 40 percent of V _U , then D = (.40) V U , and we have:

V L = V _U + t _C [(0.4) V _U ]

V L = $125,357.14 + 0.35(0.4)($125,357.14)

V L = $125,357.14 + $17,549.99

V L = $ 142,907.14

And if debt is 100 percent of V U , then D = (1.0) V U , and we have:

V L = V _U + t _C [(1.0) V _U ]

V L = $125,357.14 + 0.35(1.0)($125,357.14)

V L = $125,357.14 + $43,874.99

V L = $ 169,232.14

c)

When debt being 40 percent of the value of the levered firm, D must equal (.40) V L , so:

V L = V U + T [(.40) V L ]

V L = $125,357.14 + .35(.40)( V L )

V L = $125,357.14 + 0.14( V L )

V L = $ 125,357.14 /0.86 = $145,764.12

If the debt is 100 percent of the levered value, D must equal V L , so:

V L = V U + T [(1.0) V L ]

V L = $125,357.14 + 0.35(1.0)( V L )

V L = $125,357.14 + 0.35 V L

V L= $125,357.14 / 0.65 = $ 192,857.14