Referring to table below, calculate the market value of firm L (without a corporate income tax) if the equity amount in its capital structure decreases to $5,000 and the debt amount increases to $5,000. At this capital structure, the cost of equity is 15 percent. Round your answer to the nearest dollar. Firm U Firm L Net operating income (EBIT) $ 1,000 $ 1,000 Less: Interest payments to debt holders, I - 100 Income available to stockholders (dividends), D $ 1,000 $ 900 Total income available to security holders, I + D $ 1,000 $ 1,000 Required rate of return on debt, kd - 5 % Market value of debt, B = I/kd - $ 2,000 Required rate of return on equity,ke 10 % 11.25 % Market value of equity, E = D/ke $ 10,000 $ 8,000 Market value of firm, E + B $ 10,000 $ 10,000
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.
Referring to table below, calculate the market value of firm L (without a corporate income tax) if the equity amount in its capital structure decreases to $5,000 and the debt amount increases to $5,000. At this capital structure, the
| Firm U | Firm L | |||||||
| Net operating income (EBIT) | $ | 1,000 | $ | 1,000 | ||||
| Less: Interest payments to debt holders, I | - | 100 | ||||||
| Income available to stockholders (dividends), D | $ | 1,000 | $ | 900 | ||||
| Total income available to security holders, I + D | $ | 1,000 | $ | 1,000 | ||||
| Required |
- | 5 | % | |||||
| Market value of debt, B = I/kd | - | $ | 2,000 | |||||
| Required rate of |
10 | % | 11.25 | % | ||||
| Market value of equity, E = D/ke | $ | 10,000 | $ | 8,000 | ||||
| Market value of firm, E + B | $ | 10,000 | $ | 10,000 | ||||
$
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