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An Introduction to Debt Policy Case 31

In: Business and Management

Submitted By jstrack15
Words 617
Pages 3
Purpose
The purpose of this memo is to show my understanding of the effects of debt on the value of a firm. To do this I will summarize results from problems 1-7.

Problem One
Problem one illustrates the effect on a company’s assets if additional debt is taken on. From my calculations debt effected the cost of equity and beta which in turn effected the value of the assets. When zero debt was held beta, cost of equity and the value of assets was .80, 10%, and $20,205. When the market ratio of debt and equity changes to 23% and 77% beta, cost of capital, and value of assets rose to .96, 11%, and $21,922. Finally when the ratio changed from 43% and 57% beta, cost of equity and the value of assets once again rose to 1.19, 12% and $23,639.97. Therefore when additional debt is taken on systematic risk and the risk for equity investors goes up while the company assets appreciates.

Problem Two
In problem two, the residual income valuation is used. This valuation shows the effect on the value of equity as the capital structure is changed. From this calculation, as the debt increase residual income decreases, cost of equity increases and the value of equity decreases. However the total value of debt and equity rises as the value of debt appreciates.
Problem Three
In problem three, pure business flows and financing effects are calculated. The purpose of these calculations is separate the two cash flows where pure business cash flows measure the value of debt to the company without the tax shield and the financing effect of the company’s value measures the company’s value with the tax shield. From my calculations, debt adds value to the company to the business operations, but not as significantly as with the added value of the tax shield.
Problem Four
In problem four, the new debt is equal to the cash paid out to repurchase shares. The calculations will

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