Effect of leverage on creditors and share holders

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Reference no: EM1316317

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

0.05

0.05

Value of debt:

 

 

 

(Interest/kd)

-

-

-

Cash flow to shareholders:

 

 

 

EBIT

$1,485

$1,485

$1,485

 - Interest

0

$125

$250

Pretax profit

-

-

-

Taxes (@ 34%)

-

-

-

Net income

-

-

-

 + Depreciation

$500

$500

$500

- Capital Expense

$500

$500

$500

+ change in  net  working capital

0

0

0

- Debt amortization

0

0

0

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?

Reference no: EM1316317

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