Question

ABC has $5 billion in debt outstanding (carrying an interest rate of 9%), and 10 million shares trading at $50 per share. Based on its current EBIT of $ 200 million, its optimal debt ratio is only 30%. The firm has a beta of 1.20, and the current T-bond rate is 7%. Assuming that the operating income will increase 10% a year for the next five years and that the firm's depreciation and capital expenditures both amount to $ 100 million annually for each of the five years, estimate the debt ratio for ABC if

a. It maintains its existing policy of paying $50 million a year in dividends for the next 5 years.

b. It eliminates dividends

Answer 1

a. Debt ratio assuming policy of $50 million dividend

Current debt ratio based $200 million EBIT = 30%

Total debt = $ 5,000m

Debt ratio = total debt / total assets

Total assets = total debt / debt ratio = 5000/0.3 = $16,667m

Year (assuming $50m dividend)	1	2	3	4	5
EBIT (10% growth) each year	220	242	266	293	322
Interest cost (9% of total debt)	-450	-471	-492	-512	-532
Earning before tax	-230	-229	-225	-219	-210
Income tax (@21%)	48	48	47	46	44
Earning after tax	-182	-181	-178	-173	-166
Earning after tax	-182	-181	-178	-173	-166
Depreciation	100	100	100	100	100
Operating cash flow	-82	-81	-78	-73	-66
Capital expenditure	-100	-100	-100	-100	-100
Dividend payment	-50	-50	-50	-50	-50
Net cash flow	-232	-231	-228	-223	-216
Debt at the beginning	5,000	5,232	5,462	5,691	5,914
Additional drawdown	232	231	228	223	216
Debt at the end of year	5,232	5,462	5,691	5,914	6,130
Total assets	16,667	16,667	16,667	16,667	16,667
Debt ratio (assuming $50m dividend)	31%	33%	34%	35%	37%

b. Debt ratio assuming no dividend:

Year (assuming no dividend)	1	2	3	4	5
EBIT (10% growth) each year	220	242	266	293	322
Interest cost (9% of total debt)	-450	-466	-482	-498	-512
Earning before tax	-230	-224	-216	-205	-190
Income tax (@21%)	48	47	45	43	40
Earning after tax	-182	-177	-171	-162	-150
Earning after tax	-182	-177	-171	-162	-150
Depreciation	100	100	100	100	100
Operating cash flow	-82	-77	-71	-62	-50
Capital expenditure	-100	-100	-100	-100	-100
Dividend payment	0	0	0	0	0
Net cash flow	-182	-177	-171	-162	-150
Debt at the beginning	5,000	5,182	5,359	5,530	5,691
Additional drawdown	182	177	171	162	150
Debt at the end of year	5,182	5,359	5,530	5,691	5,842
Total assets	16,667	16,667	16,667	16,667	16,667
Debt ratio (assuming no dividend)	31%	32%	33%	34%	35%