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         ExpansionEBIT                  $500             $1,000            $1,500Interest                     0                       0                     0Net 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
Asked Oct 30, 2019

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?

 

 

 

 

 

 

check_circleExpert Solution
Step 1

Hi, since there are multiple questions posted, we will answer the first question alone. Kindly repost the remaining questions separately in order to be addressed. Thank you.

Step 2

(a)

Calculation of EPS, ROE and ROA:

Excel Spreadsheet:

...
C
Recession Expected Expansion
$1,000
В
1
2 EBIT
$500
$1,500
3Interest
$0
S0
$1,000
$10,000 $10,000 $10,000
$10,000 $10,000$10,000
$500
$1,500
4 Net Income
5 Assets
6 Equity
7 Shares Outstanding
500
500
500
$1.00
$2.00
$3.00
8 EPS
9 ROA
5.00%
10.00%
15.00%
10.00% 15.00%
10 ROE
5.00%
help_outline

Image Transcriptionclose

C Recession Expected Expansion $1,000 В 1 2 EBIT $500 $1,500 3Interest $0 S0 $1,000 $10,000 $10,000 $10,000 $10,000 $10,000$10,000 $500 $1,500 4 Net Income 5 Assets 6 Equity 7 Shares Outstanding 500 500 500 $1.00 $2.00 $3.00 8 EPS 9 ROA 5.00% 10.00% 15.00% 10.00% 15.00% 10 ROE 5.00%

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