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Question

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%.

 

                                  Current           Proposed        

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

Net income                                                               

EPS                                                            

ROA                                                             

ROE                                       

 

 

(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.

Top Answer

A. EPS ......... 1...... 2......... 3 ROA.... 0.05.... 0.1..... 0.15..... ROE..... 0.05....... View the full answer

Screenshot_20191103-234140__01.jpg

43
44
45
46
47
Recession
Expected
Expansion
48
EBIT
500
1000
1500
49
less: Interest
0
0
0
50
51
Net income
500
1000
1500
52
53
EPS
1
2
3
54
(Net income/Number of shares)
55
56
ROA
0.05
0.1
0. 15...

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