Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much does Dynamo currently pay as interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant?
A) $42 and $26.25
B) $26.25 and $42
C) $160 and $37.50
D) $37.50 and $60

Question

Quizplus · Accepted Answer

The interest Dynamo currently pays can be found by using the information that the company is financed with 25 percent debt and the cost of debt is 7 percent. If the total value of the company is represented by V, then 0.25V * 0.07 = interest paid. To find V, we use the formula for the value of a perpetuity: V = Cash Flows / Discount Rate = $150 / 0.10 = $1500. Thus, the current interest payment is 0.25 * $1500 * 0.07 = $26.25. After restructuring, if the company increases its debt such that the interest payment changes, but since the cost of debt is constant and no new structure is provided, we stick with the initial calculation. The confusion in the question's wording about restructuring seems to imply a scenario not fully described, but based on the given information, the initial interest payment calculation stands.