1. For this question, assume taxes, depreciation and amortization are always equ

Question

1. For this question, assume taxes, depreciation and amortization are always equal to zero. Consider an allequity firm with market capitalization equal to $10,000, earnings equal $600 per year, and with zero cash. a. What are the P/E and EV/EBITDA of the firm? The firm then decides to change its capital structure. It takes on $6,000 of debt and use all debt proceeds to buy back its own stock. The new debt is a perpetuity with interest rate equal to 3% per year. b. What are the P/E and EV/EBITDA of the firm after the capital structure change? c. Based on your answers to a) and b), explain why, compared to P/E ratios, EV/EBITDA is a conceptually superior valuation ratio.

Explanation / Answer

a. P/E = 10000/600 = 16.67 times
EV / EBITDA = 10000/600 = 16.67 times

b. P/E = 4000/600 = 6.67 times
EV / EBITDA = 10000/600 = 16.67 times

c. EV/EBITDA is better than P/E because it is not much affected by the capital structure. P/E only tells equity multiple but EV/EBITDA tells whole firm's multiple.

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