Question

Cavo Corporation expects an EBIT of $22,500 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? (Round your answer to 2 decimal places. (e.g., 32.16))

  

Current value

$

  

b-1	Suppose the company can borrow at 7 percent. What will the value of the firm be if the company takes on debt equal to 60 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 7 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 60 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

a.With no debt, we are finding the value of an unlevered firm, so:

V = EBIT(1-T)/R0

V = $22,500(1 - 0.35)/0.12

V = $121,875.00

  

b.

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

VL= VU + TD

If debt is 60 percent of VU, then D = (0.60) VU, and we have:

VL= VU + T[(0.60)VU]

VL = $121,875.00 + 0.35(0.60)($121,875.00)

VL = $147,468.75

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

VL= VU + T[(1.0)VU]

VL = $121,875.00 + 0.35(1.0)($121,875.00)

VL = $164,531.25

c.

According to M&M Proposition I with taxes:

VL= VU+ TD

With debt being 60 percent of the value of the levered firm, D must equal (0.60)VL, so:

VL = VU + T[(0.60)VL]

VL= $121,875.00 + 0.35(0.60)(VL)

VL = $154,272.15

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

VL = VU + T[(1.0)VL]

VL= $121,875.00 + 0.35(1.0)(VL)

VL = $187,500.00