Colt Systems will have EBIT this coming year of $33 million. It will also spend
ID: 2780793 • Letter: C
Question
Colt Systems will have EBIT this coming year of $33 million. It will also spend $12 million on total capital expenditures and increases in net working capital, and have $5 million in depreciation expenses. Colt is currently an all-equity firm with a a. If Colt's free cash flows are expected to grow by 10.1% per year, what is the market value of its equity today? b. If the interest rate on its debt is 10%, 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 57%? ExplainExplanation / Answer
a. market value of equity = free cash flow / (cost of capital - growth rate)
here,
free cash flow = EBIT *( 1 - tax rate) + depreciation - (capital expenditure and net working capital increases)
=>$33 million * (1 - 0.38) + $5 million - $12 million
=>$13.46 million.
market value of equity = $13.46 / (0.12 - 0.101)
=>$708.42 million (rounded to two decimals).
b. interest rate = 10%
the amount to be borrowed to have non negative net income = current EBIT / interest rate
=>$33 million / 0.10
=>$330 million.
c. if debt to value ratio exceeds 57%
minimum debt value = market value * 57%
=>$708.42 * 57%
=>$403.7994. million.
This amount is greater than the maximum amount to be borrowed of $33 million (as determined in b .above).
SO , there is no tax incentive today for colt to choose a debt to value ratio that exceeds 57%.