IOU has $5 billion in debt outstanding (carrying an interest rate of 9%) and 10 million shares trading at $50 per share. Based on its current EBIT of $200 million, its optimal debt ratio is only 30%. The firm has a beta of 1.20, and the current Treasury bond rate is 7%. Assuming that the operating income will increase 10% a year for the next five years and that the firm’s depreciation and capital expenditures both amount to $100 million annually for each of the five years, estimate the debt ratio for IOU if it
a. maintains its existing policy of paying $50 million a year in dividends for the next five years.
b. eliminates dividends.