Cavo Corporation expects a net income of $175,000 every year forever and all of
ID: 2719834 • Letter: C
Question
Cavo Corporation expects a net income of $175,000 every year forever and all of the net income will be paid to shareholders as dividends. The company currently has no debt but is planning to issue $120,000 perpetual debt. The interest rate on this debt is 10%. Its cost of equity is 20%. Its corporate tax rate is 35%.
What is the current value (before the debt issuing) of the company?
How much is the annual tax saving and the present value of the tax shield?
How much will be the firm value after this change in capital structure?
How much will be the value of debt and equity, respectively, after this change in capital structure?
Explanation / Answer
1) Using Gordon growth model,
Current value of the company = Net income / cost of equity = 175000 / 20% = $875,000
2) Annual tax savings = Interest rate *(tax) = 120000 * 10% * 35% = 4200
tax shield per annum = 4,200 (As calculated above)
PV of tax shield = tax shield per annum / cost of capital = 4200/20% = 21,000
3) Value of debt = 120,000
EBIT = 175000 / (1-35%) = $269,230.77
Net income every year = EBIT - interest - tax = (269,230.77 - 12000) *(1-35%) = 167200.00
So value of equity = 167200.00 / 20% = 836000
Value of firm = 836000 + 120000 = $956,000
4) Value of debt = $120,000
Value of equity = $836,000
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