Cavo Corporation expects an EBIT of $21,000 every year forever. The company curr

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.

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

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

Suppose the company can borrow at 10 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))

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

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))

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.

Explanation / Answer

(a) The current value of the company can be given by the following formula:
= EBIT-tax / Cost of equity = $21000(1-0.35)/ 12% = 113750

(b)(1) The unlevered value is $113750
If the debt = 50%= $113750 * 50% = $56875
EBIT = $21000
Interest= 10% * $56875 = $5687.5
EBT= EBIT- Interest= $21000- $5687.5 = $15312.5
Tax= 35% of EBT = $5359.38
Earning after Tax= EBT- Tax= $9953.12
Hence the Value of Firm= EAT / Cost of equity= $9953.12 / 12% = $82942.67

(b)(2) If the firm borrows 100% of the unlevered Value, debt= $113750
Interest= 10% * $113750= $11375
EBIT= $21000
Interest= $11375
EBT= EBIT- Interest= $21000- $11375 = $9625
Tax= 35% of EBT = $3368.75
Earning after Tax= EBT- Tax= $6256.25
Hence the Value of Firm= EAT / Cost of equity= $6256.25 / 12% = $53135.42

(c)(1) If the firm takes 50% debt of its levered value, debt= 50% *$82942.67 = $41471.35
EBIT= $21000
Interest= 10% * $41471.35 = $4147.14
EBT= EBIT- Interest= $21000- $4147.14 = $16852.86
Tax= 35% of EBT = $5898.50
Earning after Tax= EBT- Tax= $10954.36
Hence the Value of Firm= EAT / Cost of equity= $10954.36 / 12% = $91286.33

(c)(2) If the firm takes 100% debt of its levered value, debt= 100% *= $53135.42 = $53135.42
EBIT= $21000
Interest= 10% * $53135.42 = $5313.54
EBT= EBIT- Interest= $21000- $5313.54 = $15686.46
Tax= 35% of EBT =$5490.26
Earning after Tax= EBT- Tax= $10196.2
Hence the Value of Firm= EAT / Cost of equity= $10196.2 / 12% = $84968.33

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