Question

Susan and Celia are twins but have very different attitudes toward debt. Susan believes that firms should have a D/E ratio of 0.2 while Celia believes that the D/E ratio should be 1.1. Both sisters have agreed that Okanagan Produce Inc. (OPI) is an excellent investment. However, the D/E of 0.5 is not quite right. OPI has an EBIT of $750,000 per year and pays interest of $100,000 per year. The cost of debt is 10 percent, and the twins can also borrow and lend at that rate. All cash flows are permanent and there are zero taxes.
a. Determine what the cash flows from OPI would be if the firm had the desired D/E ratio in the table below:


b. Show the sisters how they can invest in OPI and still obtain their desired cash flows through borrowing andlending.


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  • CreatedFebruary 25, 2015
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