Question

Cede & Co. expects its EBIT to be $102,000 every year forever. The company can borrow at 6 percent. The company currently has no debt and its cost of equity is 12 percent.

What will the value be if the company borrows $185,000 and uses the proceeds to repurchase shares? Still assume a tax rate of 21%.

Answer 1

The value of the company after repurchasing shares will be $1,035,000.

Step-by-step explanation:

To calculate the value of the company after repurchasing shares, we need to calculate the value of the equity and the value of the debt. The value of the equity will be the present value of the perpetuity of $102,000, discounted at the cost of equity. Using the formula for the present value of perpetuity, the value of the equity is calculated as:

Equity Value = EBIT / Cost of Equity

Value of Debt = Borrowed Amount

Total Value of the Company = Value of Equity + Value of Debt

Using the given data, the value of equity is:

Equity Value = $102,000 / 0.12 = $850,000

Since the company borrows $185,000, the value of debt is:

Value of Debt = $185,000

Total Value of the Company = $850,000 + $185,000 = $1,035,000