Effect of leverage on creditors and share holders

Reference no: EM1316317

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.

	0% Debt/ 100% Equity	25% Debt/75% Equity	50% Debt/50% Equity
Cash flow to creditors:
Interest	0	$125	$250
Pretax cost of debt	0.05	0.05	0.05
Value of debt:
(Interest/kd)	-	-	-
Cash flow to shareholders:
EBIT	$1,485	$1,485	$1,485
- Interest	0	$125	$250
Pretax profit	-	-	-
Taxes (@ 34%)	-	-	-
Net income	-	-	-
+ Depreciation	$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?

Reference no: EM1316317

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