BusinessFinanceQ&A LibraryQ1. 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. 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. (d) If there are no taxes, calculate the WACC before and after the debt is added (assume the 7% payment on the debt = YTM). (e ) If the company stock price goes up by 2% from announcing it is adding debt to expand the business, what effect does this have on the WACC?

Question

Q1. 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.

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.

(d) If there are no taxes, calculate the WACC before and after the debt is added (assume the 7% payment on the debt = YTM).

(e ) If the company stock price goes up by 2% from announcing it is adding debt to expand the business, what effect does this have on the WACC?

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