To critically think about: The dividend paying capacity of the firm if the net income is negative and the long-term debt account of the firm if the net capital spending, net working capital, and the new stock issued is zero. Introduction: Dividend refers to the payment made by the company to the stockholders’ of the firm. It is the interest earned by the stockholders’ on their capital. The dividend is not a compulsory payment and is paid at the discretion of the company. Long-term debt refers to the dollars borrowed by the company to obtain financial leverage.

Question

D6) Suppose there are perfect capital markets with taxes. Investors expect a company to have $120 earnings before interest and taxes in one year. This company has a 25% tax rate, $100 market value of debt, and 20 shares outstanding. This company’s net working capital, depreciation expense, and capital expenditures are all expected to be zero in perpetuity. Investors expect this company to have the same earnings before interest and taxes, market value of debt, tax rate, and number of shares outstanding in perpetuity. The firm’s unlevered cost of equity is 8% and its cost of debt is 5%. Based on this information, what amount would you expect this company’s share price to be closest to? $5 $20 $40 $80 $100 $200 $400

Answer 1

Question

Chapter 2, Problem 20QP

Summary Introduction

To critically think about: The dividend paying capacity of the firm if the net income is negative and the long-term debt account of the firm if the net capital spending, net working capital, and the new stock issued is zero.

Introduction:

Dividend refers to the payment made by the company to the stockholders’ of the firm. It is the interest earned by the stockholders’ on their capital. The dividend is not a compulsory payment and is paid at the discretion of the company.

Long-term debt refers to the dollars borrowed by the company to obtain financial leverage.

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D6) Suppose there are perfect capital markets with taxes. Investors expect a company to have $120 earnings before interest and taxes in one year. This company has a 25% tax rate, $100 market value of debt, and 20 shares outstanding. This company’s net working capital, depreciation expense, and capital expenditures are all expected to be zero in perpetuity. Investors expect this company to have the same earnings before interest and taxes, market value of debt, tax rate, and number of shares outstanding in perpetuity. The firm’s unlevered cost of equity is 8% and its cost of debt is 5%. Based on this information, what amount would you expect this company’s share price to be closest to? $5 $20 $40 $80 $100 $200 $400

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