Effect of leverage on creditors and share holders.
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.
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0% Debt/ 100% Equity
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25% Debt/75% Equity
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50% Debt/50% Equity
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|
Cash flow to creditors:
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|
|
|
|
Interest
|
0
|
$125
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$250
|
|
Pretax cost of debt
|
0.05
|
0.05
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0.05
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|
Value of debt:
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|
|
|
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(Interest/kd)
|
-
|
-
|
-
|
|
Cash flow to shareholders:
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|
|
|
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EBIT
|
$1,485
|
$1,485
|
$1,485
|
|
- Interest
|
0
|
$125
|
$250
|
|
Pretax profit
|
-
|
-
|
-
|
|
Taxes (@ 34%)
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-
|
-
|
-
|
|
Net income
|
-
|
-
|
-
|
|
+ Depreciation
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$500
|
$500
|
$500
|
|
- Capital Expense
|
$500
|
$500
|
$500
|
|
+ change in net working capital
|
0
|
0
|
0
|
|
- Debt amortization
|
0
|
0
|
0
|
|
Residual Cash Flow (RCF)
|
-
|
-
|
-
|
|
Cost of equity
|
-
|
-
|
-
|
|
Value of equity (RCF/ke)
|
-
|
-
|
-
|
|
Value of equity plus value of debt
|
-
|
-
|
-
|
As the firm levers up, how does the increase in value get apportioned between the creditors and the shareholders?