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(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.

Question
Asked Nov 1, 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

(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.

check_circleExpert Solution
Step 1

a)

Calculation of EPS, ROA and ROE before debt issue:

Excel Workings:

Recession
Particulars
Expected
S1,000
$0
$1,000
$10,000
Expansion
EBIT
S500
S1,500
SO
$500
Interest
S0
Net income
$1,500
Assets
Equity
Shares outstanding
$10,000
$10,000
$10,000
$10,000
$10,000
500
500
500
EPS
S1.00
S2.00
S3.00
10.00%
ROA
5.00%
15.00%
5.00%
10.00%
ROE
15.00%
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Recession Particulars Expected S1,000 $0 $1,000 $10,000 Expansion EBIT S500 S1,500 SO $500 Interest S0 Net income $1,500 Assets Equity Shares outstanding $10,000 $10,000 $10,000 $10,000 $10,000 500 500 500 EPS S1.00 S2.00 S3.00 10.00% ROA 5.00% 15.00% 5.00% 10.00% ROE 15.00%

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Step 2

Excel Spreadsheet:

В
C
D
A
Particulars
Recession
Expected
1000
0
Expansion
1500
1
500
2 EBIT
3 Interest
4 Net income
-В2-ВЗ
C2-C3
10000
10000
500
-C4/ C7
-C4 /C5
-С4/С6
=D2-D3
10000
10000
500
=D4/D7
5 Assets
6 Equity
7 Shares outstanding
10000
10000
500
8 EPS
=B4/B7
-В4/B5
9 ROA
-D4/D5
-В4/В6
=D4/D6
10 ROE
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В C D A Particulars Recession Expected 1000 0 Expansion 1500 1 500 2 EBIT 3 Interest 4 Net income -В2-ВЗ C2-C3 10000 10000 500 -C4/ C7 -C4 /C5 -С4/С6 =D2-D3 10000 10000 500 =D4/D7 5 Assets 6 Equity 7 Shares outstanding 10000 10000 500 8 EPS =B4/B7 -В4/B5 9 ROA -D4/D5 -В4/В6 =D4/D6 10 ROE

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Step 3

b)

Calculation of EPS, ROA and ROE after debt issue:

Excel Wor...

Expected
$1,000
Expansion
$1,500
$560
$940
Particulars
Recession
ЕBIT
$500
Interest
S0
$560
Net income
$440
S500
Assets
$10,000
$10,000
$10,000
$10,000
Equity
Shares outstanding
$10,000
$10,000
500
500
500
S0.88
S1.88
EPS
S1.00
9.40%
ROA
5.00%
4.40%
5.00%
ROE
4.40%
9.40%
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Expected $1,000 Expansion $1,500 $560 $940 Particulars Recession ЕBIT $500 Interest S0 $560 Net income $440 S500 Assets $10,000 $10,000 $10,000 $10,000 Equity Shares outstanding $10,000 $10,000 500 500 500 S0.88 S1.88 EPS S1.00 9.40% ROA 5.00% 4.40% 5.00% ROE 4.40% 9.40%

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