Cavo Corporation expects an EBIT of $26,500 every year forever. The company curr

Question

Cavo Corporation expects an EBIT of $26,500 every year forever. The company currently has no debt, and its cost of equity is 15 percent. The corporate tax rate is 35 percent. a. What is the current value of the company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Company value b-1.Suppose the company can borrow at 10 percent. What will the value of the company be if it takes on debt equal to 40 percent of its unlevered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Company value b-2.Suppose the company can borrow at 10 percent. What will the value of the company be if it takes on debt equal to 100 percent of its unlevered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g, 32.16.) Company value c-1. What will the value of the company be if it takes on debt equal to 40 percent of its levered value? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Company value not round intermediate calculations and round your answer to 2 decimal places, e.g. 32.16.) Company value

Explanation / Answer

a.

Current value of the company can be calculated as unlevered firm.

Value of unlevered firm, LU = EBIT x (1 – TC)/R0

EBIT = $ 26,500

TC = 35 %

R0 = 15 %

LU = $ 26,500 x (1 – 35 %)/15 %

     = $ 26,500 x (1 – 0.35)/0.15

     = $ 26,500 x 0.65/0.15

     = $ 17,225 /0.15

     = $ 114,833.3333 or $ 114,833.33

b-1.

Formula for computation of value of levered firm is:

VL = VU + TC D

Debt, D = 40 % of VU

Value of unlevered firm, VL = $ 114,833.3333 + 0.35 x (0.4 x $ 114,833.3333)

      = $ 114,833.3333 + 0.35 x (0.4 x $ 114,833.3333)

      = $ 114,833.3333 + $ 16,076.66667

      = $ 130,910

b-2.

Value of levered firm, VL = VU + TC D

Debt, D = 100 % of VU

VL = $ 114,833.3333 + 0.35 x (1 x $ 114,833.3333)

    = $ 114,833.3333 + $ 40191.66667

   = $ 155,025

c-1.

VL = VU + TC D

Debt, D = 40 % of VL

VL = $ 114,833.3333 + 0.35 x 0.40 x VL

     = $ 114,833.3333 + 0.14 x VL

VL – 0.14 VL = $ 114,833.3333

0.86 VL = $ 114,833.3333

VL = $ 114,833.3333/0.86

     = $ 133,527.1318 or = $ 133,527.13

c-2.

Value of unlevered firm, VL = VU + TC D

Debt, D =100 % of VL

VL = $ 114,833.3333 + 0.35 x 1 x VL

    = $ 114,833.3333 + 0.35 VL

VL- 0.35 VL = $ 114,833.3333

0.65 VL= $ 114,833.3333

VL= $ 114,833.3333/0.65

VL= $ 176,666.6667 or $ 176,666.67

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