Question

You are currently an investor in test mining that earns an EBIT of $ 10,000 each year. The firm’s total assets are currently worth $ 80,000. 30% of the firm’s assets are currently funded by debt at a cost of 8%. There are totally 1000 shares outstanding of which you own 10 shares. In the recent board meeting, the executives have come up with the decision to push the firm’s leverage to 45% by replacing suitable amount of equity with debt. Suppose there are no taxes, the firm’s WACC is 10%, and you can lend/borrow at 8%, prove that increasing leverage is a value neutral proposition for you

Answer 1

In the given case,

the EBIT is 10000. Total assets are 80000. The debt is 30% of assets i.e. 24000. The current leverage ratio (Total debt / total assets) is 0.3. In order to increase it leverage ratio to 45% the part of equity to be narrow down and debt to be increase from 30% to 45%. When the debt is increase the interest cost is also increased, due the this the bottom line figure is reduced. But the amount difference is 0.096 per share. The cost of equity is higher per share as compared to this. also since the company have assets of 80000 it is vible to have debt. The reason behind this is cost of debt is cheaper compared to cost of debt. In this was it can neutralized its proposition after increasing the leverage.