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.


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