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Finance Capital structure : Calculation of Sum of values of pure business flows

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Calculation of Sum of values of pure business flows and financing effect : In the preceding problem, we divided the value of all the assets between two classes of investors: creditors and shareholders.

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									              Sub: Finanace                                                                     Topic: Capital Structure



              Question:
              Calculation of Sum of values of pure business flows and financing effect

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              In the preceding problem, we divided the value of all the assets between two classes of
              investors: creditors and shareholders. This process tells us where the change in value is going,
              but it sheds little light on where the change is coming from. Let’s divide the free cash flows of
              the firm into pure business flows and cash flows resulting from financing effects. Now, an axiom
              in finance is that you should discount cash flows at a rate consistent with the risk of those cash
              flows. Pure business flows should be discounted at the unlevered cost of equity (i.e., the cost of
              capital for the unlevered firm). Financing flows should be discounted at the rate of return
              required by the providers of debt.


                                                         0%                25%               50%
                                                       Debt/100          Debt/75%          Debt/50%
                                                        Equity            Equity            Equity
               Pure business cash flows:
               EBIT                                         $1,485             $1,485          $1,485
               Taxes (@ 34%)                                ($505)             ($505)          ($5
								
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