Cavo Corporation expects an EBIT of $29,550 every year forever. The company curr

Question

Cavo Corporation expects an EBIT of $29,550 every year forever. The company currently has no debt, and its cost of equity is 11 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 7 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 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))

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 $29,550 every year forever. The company currently has no debt, and its cost of equity is 11 percent. The corporate tax rate is 35 percent.

Explanation / Answer

Solution:

a) Current Value of the company

Current Value of Firm = Earnings attributable to Equity Common Shareholders / Cost of Equity

Current Value of Firm = $19,207.50 / 0.11 = $174,613.64

Cost of Equity = 11%

Earnings attributable to Equity Common Shareholders = EBIT (1 – Tax Rate) = $29,550 x (1 – 0.35) = $19,207.50

b-1)

As per MM approach with taxes of Capital Structure Theories,

Value of Levered Firm = Value of Unlevered Firm + Debt x Tax Rate

Hence Value of Levered Firm = $174,613.64 + ($87,306.82 x 35%)

= $174,613.64 + $30,557.39 = $205,171.03

b-2)

As per MM approach with taxes of Capital Structure Theories,

Value of Levered Firm = Value of Unlevered Firm + Debt x Tax Rate

= $174,613.64 + ($174,613.64 x 100% x 35%)

= $174,613.64 + $61,114.77

= $235,728.41

part C-1 & C-2 ---- please clarify of which value the debt is 100% (the value calculated in Part b-1 or Part b-2

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