Question

Suppose you observe a mature, unlevered company with a constant cash flow and market value of equity as

EBIT = 100

E = 1000

Compute the cost of unlevered capital, Ru

Suppose you observe another company with identical cash flow, but different capital structure. The cost of debt and equity of this company are as follows

Rd = 5%

Re = 15%

What is the value of debt of this company?

Suppose you decide to invest in the unlevered firm, however you would like your investment have the same return as that of the levered equity. Explain in detail how you would do to achieve your goal.

Answer 1

1) EBIT =100 AS NO DEBT EBIT IS EQUAL TO EARINING ASSUME NO TAX

SO ROE= EBIT/CAPITAL INVESTED *100 =100/1000*100=10%(IN UNLEVERED FIRM)

2) IN CASE OF LEVERED FIRM

LETS SUPPOSE X BE THE INVESTMENT IN DEBT THEN PROPORTION OF INVESTMENT (1-X)R_e+X*R_d=10%

We assume both gives same return on Equity.

Then up on substituting Re=15%: Rd=5%

(1-x)0.15+(x)0.05=0.1

0.15-.0.15x+0.05x=0.1

x=0.5

there fore the out of total investment 50% is invested by debt and balance 50% by equity.

This implies that any income in excess of 1000 after paying of debt amount increases the return of equity

The equity holder have owner ship right.

When compare to debt rist of return is high.

Thanks. With pleasure, For Further clarification if nay needed contact.