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Effect of leverage on creditors and share holders.
In finance, as in accounting, the two sides of the balance sheet must be equal. In the previous problem, we valued the asset side of the balance sheet. To value the other side, we must value the debt and the equity, and then add them together.
0% Debt/ 100% Equity
25% Debt/75% Equity
50% Debt/50% Equity
Cash flow to creditors:
Interest
0
$125
$250
Pretax cost of debt
0.05
Value of debt:
(Interest/kd)

Cash flow to shareholders:
EBIT
$1,485
 Interest
Pretax profit
Taxes (@ 34%)
Net income
+ Depreciation
$500
 Capital Expense
+ change in net working capital
 Debt amortization
Residual Cash Flow (RCF)
Cost of equity
Value of equity (RCF/ke)
Value of equity plus value of debt
As the firm levers up, how does the increase in value get apportioned between the creditors and the shareholders?
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