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The value of Asset changed because the WACC as a divider of Value of asset calculation is decreased as the FCF constant
Specifically change on Leverage Beta which affected from figures of debt then it affecting on Cost of Equity, finally Re would be component
ally Re would be component of WACC calculation
0% Debt / 25% Debt / 50% Debt /
100% Equity 75% Equity 50% Equity
Cash flow to creditors:
Interest $ - $ 125 $ 250
Pretax cost of debt 0.05 0.05 0.05
Value of Debt (Interest/Kd) $ - $ 2,500 $ 5,000
− Debt amortization 0 0 0
Residual cash flow (RCF) $ 980 $ 898 $ 815
Cost of equity 9.80% 10.75% 12.16%
Value of equity (RCF/ke) $ 10,001 $ 8,351 $ 6,701
Value of equity plus value of debt $ 10,001 $ 10,851 $ 11,701
As the firm levers up, how does the increase in value get apportioned between the creditors and the shareholders?
To propotionate between the creditors and shareholders, use the Weighted Market value of Debt for creditors and Weighted market va
rs and Weighted market value of equity for shareholders
Q3 0% Debt 25%Debt 50% Debt
100% Equity 75% Equity 50% Equity
Pure business cash flow :
EBIT $ 1,485 $ 1,485 $ 1,485
Taxes (34%) $ 505 $ 505 $ 505
EBIAT $ 980 $ 980 $ 980
+Depreciation $ 500 $ 500 $ 500
-Capital exp. $ (500) $ (500) $ (500)
`+Change in net working capital $ - $ - $ -
Cash flow $ 980 $ 980 $ 980
Unlevered beta 0.8 0.8 0.8
Risk-free rate 0.05 0.05 0.05
Market risk premium 0.06 0.06 0.06
Unlevered WACC 9.80% 9.80% 9.80%
Value of pure business flow (Cash
flow/Unlevered WACC) 10,001 10,001 10,001
Financing cash flows
Interest $ - $ 125 $ 250
Tax reduction $ - $ 43 $ 85
Pretax cost of debt 0.05 0.05 0.05
Value of financing effect $ - $ 850 $ 1,700
Total value 10,001 10,851 11,701
Q4. 0% Debt 25%Debt 50% Debt
100% Equity 75% Equity 50% Equity
Total market value of equity $ 10,000 $ 8,350 $ 6,700
Cash paid out $ - $ 2,500 $ 5,000
Number of original shares 1000 1000 1000
Total value per share $ 10.00 $ 10.85 $ 11.70
Q5. Leverage is good for shareholders since it could increase the total value per share. Proved by problem above
Levering/unlevering is a work done by the company's management, not by the shareholders.
Shareholders should pay for premium for shares of levered companies when the leverage could bring the company to further step of it
In other words, in the near future, company could increase value of the shares.
Q6.
problem above
Before After
Recapitalization Recapitalization
New borrowing $ 1,565,686