Colt Systems will have EBIT this coming year of $ 17million. It will also spend $7 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 8.7% 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 49%? Explain.

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12 March, 12:58

Colt Systems will have EBIT this coming year of $ 17million. It will also spend $7 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 8.7% 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 49%? Explain.

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Ali House · Answer 1

a) market value of equity 589,488,461.54

b) it can loan up to 212,500,000

c) as the liabilities provides a tax shield because, interest expense are tax deductible while dividends don't The companu find a tax incentive to take debt

Explanation:

Free Cash Flow for the firm:

17,000,000 earnings before taxes

- 7,000,000 CAPEX

+ 3,000,000 depreciation

- 5,950,000 income tax*

7,050,000 FFCF

we solve using the gordon grow model:

7,050,000x1.087 / (0.10 - 0.087) = 589,488,461.54

* income tax: 17,000,000 x 35% = 5,950,000

b) We can consider the income as the installment of a perpetuity

17,000,000 / 0.08 = 212,500,000