Colt Systems will have EBIT this coming year of $ 16 million. It will also spend
ID: 2798262 • Letter: C
Question
Colt Systems will have EBIT this coming year of
$ 16
million. It will also spend
$ 4
million on total capital expenditures and increases in net working capital, and have
$ 2
million in depreciation expenses. Colt is currently an all-equity firm with a corporate tax rate of
30 %
and a cost of capital of
12 %
.
a. If Colt's free cash flows are expected to grow by
10.3 %
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
40 %
?
Explain.
Explanation / Answer
a)
FCF = EBIT*(1-t) + Depreciation - Change in NWC - Capex = 16*(1-30%) + 2 - 4 -4 = $ 5.2 M
Market Value of Equity = FCF*(1+g) / (k-g) = 5.2*(1+10.3%)/ (12%-10.3%) = $ 337.38 M
b)
Given EBIT = $ 16 M
For Cold to to have non negative net income ie Minimum Net Income of $ 0 , the interest expenses must be $16 that is 10% of $ 160. So $ 160 can be the maximum amount to be borrowed by Colt which 47.4 % of firm value. So there is tax incentive for debt to value to be above 40%. In the above case, Colt need not pay any taxes at all.