Question

Assume an initial scenario where a levered firm has total assets of $8,000, earnings before interest and taxes of $600, 400 shares of stock outstanding, a debt-equity ratio of .25, and a cost of debt of 7 percent. Now assume a second scenario where the firm changes to an all-equity structure by issuing new shares to pay off debt while a shareholder holding 10 percent of the stock borrows funds at 7 percent and uses homemade leverage to offset the firm's change in capital structure. Ignore taxes. What are the net earnings for this shareholder under the initial scenario? Under the second scenario?
A) $90.00; $90.00
B) $90.00; $112.50
C) $48.80; $38.80
D) $48.80; $48.80
E) $45.00; $48.80

Answer 1

Answer:

D) $48.80; $48.80

Explanation:

Total assets = 8000

Debt equity = 0.25

Equity = 6400

Debt = 1600

Calculation of cash flow for equity holders

EBIT =             600

Interest =         112 (1600*7%)

Net Income =  488

10% Holding = 488 * 10%

10% Holding = $48.80   (Answer 1)

Income for shareholder

Value of shareholders equity = 10% * 6400 = 640

Now levered form goes all equity firm

Equity = 8,000

10% Holding = 800

So, Shareholder has to borrow 160 to keep holding 10%

Borrow = 800 - 640

Borrow = 160

Now, EBIT =    600

Interest =          0

Net Income = 600

Income to Shareholder

10% Holding = 600 * 10% = 60

Less: Interest = 160*7% =    11.2 (Interest on borrowing)

Income =                              $48.80 (Answer 2)