Cavo Corporation expects an EBIT of $19,750 every year forever. The company curr
ID: 2660397 • Letter: C
Question
Cavo Corporation expects an EBIT of $19,750 every year forever. The company currently has no debt, and its cost of equity is 15 percent. The corporate tax rate is 35 percent.
What is the current value of the company? (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 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 $19,750 every year forever. The company currently has no debt, and its cost of equity is 15 percent. The corporate tax rate is 35 percent.
Explanation / Answer
Given details for Cavo Corporation,
Earnings Before Interest and Taxes (EBIT) = $19,750/year
Cost of equity (ke) = 15%
Corporate Tax Rate (t) = 35%
Currently, No Debt => D = 0
EBIT is expected to be generated forever, so growth rate (g) = 0
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Answer a)
Since, debt is zero, we take cost of equity as discounting rate.
Cash inflow after tax per year [i.e. Profit After Tax [PAT] ]is given by = EBIT * (1 - t ) .........................[Formula]
= 19750 * (1-0.35)
= $12,837.5 -------------------- (i)
Present value of perpetual annuity is given by the formula :
where,
A = Annity or Annual Cash flow (here inflow)
i = Discounting Rate, Here Cost of equity
Therefore, we have,
Current Value of the company = (12837.5) / (0.15) ------------------------------[From Given and (i)]
=> Current Value of the company = $85,583.33 ---------------------------[Answer (rounded upto two decimal places]
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Answer b-1)
Cost of debt = 10% ----------------------------- [Given]
Proportion of Debt = 50% of unlevered value (unlevered value is value of equity only) (unlevered value is value of equity only) ----------------------------- [Given]
Since, the capital structure has both debt and equity, thus we have to take,
Weighted Average Cost of Capital (WACC) as the discounting rate
WACC is given by the formula:
Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate
From given, we have. E/V = 2/3 and D/V = 1/3
Therefore, WACC = (2/3) * 0.15 + (1/3) * 0.10 * (1 - 0.35)
=> WACC = 0.12167 = 12.167% ------------------------(ii)
Here as you can see, we have taken the after tax cost of debt in calculation of WACC so, we do not take debt expense effect again into tax calculation
Present value of perpetual annuity is given by the formula :
where,
A = Annity or Annual Cash flow (here inflow)
i = Discounting Rate, Here WACC
Therefore, we have,
Current Value of the company = (12837.5) / (0.12167) ------------------------------[From Given (i) and (ii)]
=> Current Value of the company = $105,513.70 ---------------------------[Answer (rounded upto two decimal places]
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Answer b-2)
Cost of debt = 10% ----------------------------- [Given]
Proportion of Debt = 100% of unlevered value (unlevered value is value of equity only) ----------------------------- [Given]
Since, the capital structure has both debt and equity, thus we have to take,
Weighted Average Cost of Capital (WACC) as the discounting rate
WACC is given by the formula:
Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate
From given, we have. E/V = 0.5 and D/V = 0.5
Therefore, WACC = 0.5 * 0.15 + 0.5 * 0.10 * (1 - 0.35)
=> WACC = 0.1075 = 10.75% ------------------------(iii)
Here as you can see, we have taken the after tax cost of debt in calculation of WACC so, we do not take debt expense effect again into tax calculation
Present value of perpetual annuity is given by the formula :
where,
A = Annity or Annual Cash flow (here inflow)
i = Discounting Rate, Here WACC
Therefore, we have,
Current Value of the company = (12837.5) / (0.1075) ------------------------------[From Given,(i) and (iii)]
=> Current Value of the company = $119,418.60 ---------------------------[Answer (rounded upto two decimal places]
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Answer c-1)
Cost of debt = 10% ----------------------------- [Given]
Proportion of Debt = 50% of levered value (i.e. value of debt plus value of equity) (i.e. value of debt plus value of equity) ----------------------------- [Given]
Since, the capital structure has both debt and equity, thus we have to take,
Weighted Average Cost of Capital (WACC) as the discounting rate
WACC is given by the formula:
Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate
From given, we have. E/V = 0.5 and D/V = 0.5
Therefore, WACC = 0.5 * 0.15 + 0.5 * 0.10 * (1 - 0.35)
=> WACC = 0.1075 = 10.75% ------------------------(iv)
Here as you can see, we have taken the after tax cost of debt in calculation of WACC so, we do not take debt expense effect again into tax calculation
Present value of perpetual annuity is given by the formula :
where,
A = Annity or Annual Cash flow (here inflow)
i = Discounting Rate, Here WACC
Therefore, we have,
Current Value of the company = (12837.5) / (0.1075) ------------------------------[From Given,(i) and (iv)]
=> Current Value of the company = $119,418.60 ---------------------------[Answer (rounded upto two decimal places]
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Answer c-2)
Cost of debt = 10% ----------------------------- [Given]
Proportion of Debt = 100% of levered value (i.e. value of debt plus value of equity) levered value (i.e. value of debt plus value of equity) (i.e. value of debt plus value of equity) ----------------------------- [Given]
Since, the capital structure has only debt, thus we have to take,
after tax cost of debt as the discounting rate
Discounting Rate = Cost of Debt (kd) * ( 1 - t )
Therefore, Discounting Rate = 0.10 * (1 - 0.35) = 0.065
=> Discounting Rate = 0.065 = 6.50% ------------------------(iii)
Here as you can see, we have taken the after tax cost of debt so, we do not take debt expense effect again into tax calculation
Present value of perpetual annuity is given by the formula :
where,
A = Annity or Annual Cash flow (here inflow)
i = Discounting Rate, Here after tax cost of debt
Therefore, we have,
Current Value of the company = (12837.5) / (0.065) ------------------------------[From Given,(i) and (iii)]
=> Current Value of the company = $197,500 ---------------------------[Answer (rounded upto two decimal places]
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