idends at a rate of 28%. If the firm were to convert £4 million of equity into debt at an interest rate of 10% and John holds all the debt, calculate the total cash flow to John after he pays personal taxes. Compare this to John’s total cash flow a
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Smith Manufacturing is currently all equity financed, had EBIT of £2 million, and is in the 34% tax bracket. John, the company's founder, is the lone shareholder. Assume that all earnings are paid out as dividends. Now consider the fact that John must pay personal tax on the dividends he will receive. John pays taxes on interest at a rate of 33%, but pays taxes on dividends at a rate of 28%. If the firm were to convert £4 million of equity into debt at an interest rate of 10% and John holds all the debt, calculate the total cash flow to John after he pays personal taxes. Compare this to John’s total cash flow after personal taxes if the firm remains unlevered. What is the change in John’s cash flows after personal taxes if the firm becomes levered?
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