Question

This is a two-part question: We have a firm that needs $1000 to obtain a new machine for its business. It can either issue stock or bonds, or some combination of both. If it issues bonds it will have to pay $8.00 in interest for every $100 borrowed. Finally, assume the company will earn $150 in good years and $75 in bad years, with equal probability. The first part of the question is to (a) determine the payment to the equity holders under the following three scenarios: (i) the first is the firm uses 0% debt financing; (ii) the second is the firm uses 50% debt financing, and (iii) the third finds the firm using 80% debt financing. The second part of the question is to (b) determine the expected equity return (%) under each scenario.

Answer 1

ANSWER:

Expected earnings of the firm=$150*0.5+$75*0.5=$112.5.

(a) (i)

In case of 0% debt all the earnings will be paid to equity holders, i.e. $112.5.(Assuming 0 retained earnings in all cases).

(ii)

In case of 50% debt financing ($500) interest of $40($500*8%) is to be paid. Earnings after interest, $72.5($112.5-40)  will be paid to the equity holders.

(iii)

In case of 80% debt financing ($800) interest of $64($800*8%) is to be paid. Earnings after interest, $48.5($112.5-64)  will be paid to the equity holders.

(b)

Expected equity return =Earnings to equity holders/Investment by Equity holders.

(i) Expected equity return=$ 112.5/$1000*100=11.25%.

(ii) Expected equity return=$ 72.5/$500*100=14.50%.

(iii) Expected equity return=$ 48.5/$200*100=24.25%.