4. What remains to be seen however, is whether shareholders are better or worse off with...

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4. What remains to be seen however, is whether shareholders are better or worse off with more leverage. Problem 2 does not tell us, because there we computed total value of equity, and shareholders care about value per share. Ordinarily, total value will be a good proxy for what is happening to the price per share, but in the case of a relevering firm, that may not be true. Implicitly we assumed that, as our firm in problems 1-3 levered up, it was repurchasing stock on the open market (you will note that EBIT did not change, so management was clearly not investing the proceeds from the loans in cash-generating assets). We held EBIT constant so that we could see clearly the effect of financial changes without getting them mixed up in the effects of investments. The point is that, as the firm borrows and repurchases shares, the total value of equity may decline, but the price per share may rise. Now, solving for the price per share may seem impossible, because we are dealing with two unknowns-share price and change in the number of shares: Share Price = Total Market Value of Equity (Original - Repurchased Shares Shares) But by rewriting the equation, we can put it in a form that can be solved: Share Total Market Cash Price = Value of Equity + Paid Out # Original Shares Referring to the results of problem 2, let's assume that all the new debt is equal to the cash paid to repurchase shares. Please complete the following table: Total Market Value of Equity (from Prob. 2) (this is like E1) Cash Paid Out (to buy back shares) (this is like D1) # Original Shares Total Value Per Share Number of shares repurchased Number of shares outstanding 0% Debt/ 100% Equity 1000 25% Debt/ 75% Equity 1000 50% Debt/ 50% Equity 1000 2. 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. Cash Flow to Creditors: (interest) Pretax Cost of Debt Value of Debt: (CF/rd) Cash Flow to Shareholders: EBIT Interest Pretax Profit Taxes (@34%) Net Income + Depreciation - Capital Exp. + Change in net working capital -Debt Amortiz. Residual Cash Flow Cost of Equity (from Prob. 1) 0% Debt/ 100% Equity S $ $ 1,485.00 S $ $ $ S 5.00% S S S $ 1,485.00 504.90 980.10 500.00 (500.00) 980.10 9.800% $ 10,001.02 25% Debt/ 75% Equity $ 10,001.02 $ 125.00 5.00% $ 2,500.00 $ 1,485.00 $ (125.00) $ 1,360.00 $ 462.40 897.60 500.00 $ $ $ S S $ (500.00) 897.60 10.749% $ 8,350.93 50% Debt/ 50% Equity $10,850.93 $ 250.00 5.00% $ 5,000.00 Value of Equity (CF/re) Value of Equity plus value of debt As the firm levers up, how does the increase in value get apportioned between creditors and shareholders? As a firm gains more debt, they initially increase the overall value of the firm. The increase in value is apportioend between creditors and sahreholders are that the creditors recieve the interest payments whereas the shareholders have claims to the residual cash flows from the firm. While the value of equity seems to get lower this doesn't mean it decreases in value because there would be less outstanding shares. The firm does gain tax benefits and an increase in firm value at the expense of having $ 1,485.00 $ (250.00) $ 1,235.00 S 419.90 $ 815.10 500.00 $ (500.00) S S $ 815.10 12.164% $ 6,700.82 $11,700.82 4. What remains to be seen however, is whether shareholders are better or worse off with more leverage. Problem 2 does not tell us, because there we computed total value of equity, and shareholders care about value per share. Ordinarily, total value will be a good proxy for what is happening to the price per share, but in the case of a relevering firm, that may not be true. Implicitly we assumed that, as our firm in problems 1-3 levered up, it was repurchasing stock on the open market (you will note that EBIT did not change, so management was clearly not investing the proceeds from the loans in cash-generating assets). We held EBIT constant so that we could see clearly the effect of financial changes without getting them mixed up in the effects of investments. The point is that, as the firm borrows and repurchases shares, the total value of equity may decline, but the price per share may rise. Now, solving for the price per share may seem impossible, because we are dealing with two unknowns-share price and change in the number of shares: Share Price = Total Market Value of Equity (Original - Repurchased Shares Shares) But by rewriting the equation, we can put it in a form that can be solved: Share Total Market Cash Price = Value of Equity + Paid Out # Original Shares Referring to the results of problem 2, let's assume that all the new debt is equal to the cash paid to repurchase shares. Please complete the following table: Total Market Value of Equity (from Prob. 2) (this is like E1) Cash Paid Out (to buy back shares) (this is like D1) # Original Shares Total Value Per Share Number of shares repurchased Number of shares outstanding 0% Debt/ 100% Equity 1000 25% Debt/ 75% Equity 1000 50% Debt/ 50% Equity 1000 2. 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. Cash Flow to Creditors: (interest) Pretax Cost of Debt Value of Debt: (CF/rd) Cash Flow to Shareholders: EBIT Interest Pretax Profit Taxes (@34%) Net Income + Depreciation - Capital Exp. + Change in net working capital -Debt Amortiz. Residual Cash Flow Cost of Equity (from Prob. 1) 0% Debt/ 100% Equity S $ $ 1,485.00 S $ $ $ S 5.00% S S S $ 1,485.00 504.90 980.10 500.00 (500.00) 980.10 9.800% $ 10,001.02 25% Debt/ 75% Equity $ 10,001.02 $ 125.00 5.00% $ 2,500.00 $ 1,485.00 $ (125.00) $ 1,360.00 $ 462.40 897.60 500.00 $ $ $ S S $ (500.00) 897.60 10.749% $ 8,350.93 50% Debt/ 50% Equity $10,850.93 $ 250.00 5.00% $ 5,000.00 Value of Equity (CF/re) Value of Equity plus value of debt As the firm levers up, how does the increase in value get apportioned between creditors and shareholders? As a firm gains more debt, they initially increase the overall value of the firm. The increase in value is apportioend between creditors and sahreholders are that the creditors recieve the interest payments whereas the shareholders have claims to the residual cash flows from the firm. While the value of equity seems to get lower this doesn't mean it decreases in value because there would be less outstanding shares. The firm does gain tax benefits and an increase in firm value at the expense of having $ 1,485.00 $ (250.00) $ 1,235.00 S 419.90 $ 815.10 500.00 $ (500.00) S S $ 815.10 12.164% $ 6,700.82 $11,700.82

Answer rating: 100% (QA)

Based on the table provided we can observe the following 0 Debt100 Equity Total Market Value of Equi... View the full answer