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Colt Systems will have EBIT this coming year of $15 million
Colt Systems will have EBIT this coming year of $15 million. It will also spend $6 million on total capital expenditures and increases in net working? capital, and have $3 million in depreciation expenses. Colt is currently an? all-equity firm with a corporate tax rate of 35% and a cost of capital of 10%.
a) If? Colt's free cash flows are expected to grow by 8.5% per? year, what is the market value of its equity? today?
b) If the interest rate on its debt is 8%?, how much can Colt borrow now and still have? non-negative net income this coming? year?
c) Is there a tax incentive today for Colt to choose a? debt-to-value ratio that exceeds 50%?? Explain.
Expert Solution
a) Computation of the market value of equity:-
Free cash flow = (EBIT * (1 - Tax rate)) + Depreciation - Capital expenditure and net working capital increases
= ($15 * (1 - 35%)) + $3 - $6
= $9.75 + $3 - $6
= $6.75 million
Market value of equity = Free cash flow / (Cost of capital - Growth rate)
= $6.75 / (10% - 8.5%)
= $6.75 / 1.5%
= $450 million
b) Computation of the amount to be borrowed to have non negative net income:-
Amount to be borrowed to have non negative net income = Current EBIT / Interest rate
= $15 / 8%
= $187.50
c) If debt to value ratio exceeds 50%
Minimum debt value = Market value * 50%
= $450 * 50%
= $225 million
The amount ($225 million) is greater than the maximum amount to be borrowed of $187.50 million. So, there is no tax incentive today for colt to choose a debt to value ratio that exceeds 50%.
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