Question: In finance, as in accounting, two (2) sides of the balance sheet must be equal. To value the other side, we must value the debt & 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
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0
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$125
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$250
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Pretax cost of debt
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0.05
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0.05
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0.05
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Value of debt:
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(Interest/kd)
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-
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-
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-
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Cash flow to shareholders:
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|
|
|
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EBIT
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$1,485
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$1,485
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$1,485
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- Interest
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0
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$125
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$250
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Pretax profit
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-
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-
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-
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Taxes (@ 34%)
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-
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-
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-
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Net income
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-
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-
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-
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+ Depreciation
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$500
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$500
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$500
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- Capital Expense
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$500
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$500
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$500
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+ change in net working capital
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0
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0
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0
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- Debt amortization
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0
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0
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0
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Residual Cash Flow (RCF)
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-
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-
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-
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Cost of equity
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-
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-
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-
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Value of equity (RCF/ke)
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-
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-
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-
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Value of equity plus value of debt
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-
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-
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-
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As the firm levers up, how does the rise in value get apportioned between the creditors & the shareholders?