Question

Cloudstreet Ltd has a current EBIT of $1.5 million per annum. The CFO approaches the Board...

Cloudstreet Ltd has a current EBIT of $1.5 million per annum. The CFO approaches the Board and advises them that they have devised a strategy which will lower the company’s cost of capital by a full 1%. How will this change the value of the company? Support your answer using theory and calculations.

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Answer #1

The value of the company is determined by discounting the future cash flows of the business at the cost of capital. The earnings before interest and taxes are used to determine the free cash flows of the business. Higher the cost of capital higher will be the discount rate and lower will be the value of the company. If the cost of capital decreases the value of the company will increase.

Assuming a perpetual period and a cost of capital of 10%, the value of the company = EBIT/Rate

= $1.5 m/ 10% = $15 million

Wit ha reduction in the cost of capital, the value will be $1.5m/ 9%

= $16.67 million

Hence we see that with a decrease in the cost of capital, the value of the company increases.

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