Consider an all-equity firm that is contemplating going into debt. The market value of equity is calculated as
Free Cash Flow/required rate of return.
You can choose if you want to include a tax rate or not. If you include a tax rate, choose 30%.
Assets $10,000 $18,000
Debt $0 $8,000
Equity $10,000 $10,000
Debt/Equity ratio 0.00 1.00
Interest rate n/a 7%
Shares outstanding 500 500
Share price $20 $20
(a) If the required rate of return on unlevered equity is 10%, fill out the following table for the company before the debt is issued:
Recession Expected Expansion
EBIT $500 $1,000 $1,500
Interest 0 0 0
(b) If the company adds the proposed amount of debt and EBIT is expected to expand proportionally, fill out the table in (a) after the debt is issued.
(c) If an investor is not happy with the debt the company added, show the steps the investor can take to do homemade "un-leverage" and earn the same ROA and ROE as in part (a). Set up a table to show that the unleveraged works.
A. EPS ......... 1...... 2......... 3 ROA.... 0.05.... 0.1..... 0.15..... ROE..... 0.05....... View the full answer