Equilibrant Industries is composed entirely of equity and is valued at $1.5 mill
ID: 2793971 • Letter: E
Question
Equilibrant Industries is composed entirely of equity and is valued at $1.5 million. Durst Co. has $400,000 worth of debt costing 9% that becomes due next year with interest. Both firms compete in the same market, and next year's expected cash flows for both firms are $300,000 with 50% probability and $3.15 million with 50% probability. What is the expected cash flow of both firms, ignoring taxes and bankruptcy costs? What is the expected equity return for Equilibrant? How much debt is due at the end of the year for Durst? What is the discounted value of Durst's debt? What is the expected return on its equity, assuming that Durst is valued comparably to Equilibrant?
Explanation / Answer
Value of equity of Equilibrant industries is $1.5 million.
Expected cash flow for next year : $300,000 with 50% probability and $3.15million with 50% probability
Therefore, expected value of cash flow= $300,000*0.5+$3.15m *0.5= $150,000+$1,575,000=$1,725,000
This will be the same expected cash flow for Durst Co as well as that entity also have same cash flows
Expected equity return for Equilibrant = ($1,725,000-$1.5 million)/ ($1.5million)= $225,000/$1.5million= 15%
We have calculated this by using excess return over equity in numerator and value of equity in denominator
Now Durst Co has $400,000 worth of debt costing 9% that becomes due next year with interest. So next year, Durst Co will pay both principal and interest on this debt .
Interest on debt = $400,000 *0.09= $ 36,000
Total debt due including principal and interest= $400,000+$36,000= $436,000
Discounted value of Durst's debt is nothing but the value of debt today excluding interest which will accrue over next year= $400,000
If Durst is valued comparably to Equilibrant then it will also have total value of $1.5 million, Now out of this we know $400,000 is debt and therefore, equity component in Durst Co= $1,500,000-$400,000= $ 1,100,000
total Expected value of cash flow = $1,725,000
Expected value of cash flow that will be available for equity holders= $ 1,725,000- $ 436,000 (total debt due next year)
= $ 1,289,000
Therefore, return on equity= Excess return over equity/ value of equity= ($1,289,000-$1,100,000)/ ($1,100,000)
= $189,000/$1,100,000= 17.18%
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