Answer:
(a) (i) 0
(ii) 1
(b) $27,775; 0.784
(c) $166,650; 0.377
Explanation:
a-1)
Interest paid = market value of debt × cost
= $101,000 × 0.1
= $10,100
EBIT = $10,100
Cash flow to shareholders = EBIT - Interest paid
= $10,100 - $10,100
= 0
value of equity = 0
a-2)
Debt to value = total debt ÷ total value of firm
total debt value debt is $101,000
No default is likely to occur
Hence , total value of firm = total debt
= $101,000
Hence, the debt to value ratio is 1
.
(b)
At growth rate 2%
EBIT next year will be:
= $10,100 × (1.02)
= $10,302
Since there is no risk, the required return for shareholders is the same as the required return on the company’s debt.
The payments made to the shareholders increase at 2% every year.
Present value of these payments
:
Value of equity = [ $10,302 ÷ (0.1 - 0.02)] - [$10,100 ÷ 0.1]
= $128,775 - $101,000
= $27,775
Debt to value ratio = $101,000 ÷ ($101,000 + $27,775)
= 0.784
(c)
At growth rate of 6%
EBIT next year will be:
= $10,100 × (1.06)
= $10,706
Present value of these payments
:
Value of equity = [ $10,706 ÷ (0.1 - 0.06)] - [$10,100 ÷ 0.1]
= $267,650 - $101,000
= $166,650
Debt to value ratio = $101,000 ÷ ($101,000 + $166,650)
= 0.377
