How much will a firm need in cash flow before tax and interest to satisfy debt holders and equity holders if: the tax rate is 35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring an 6% return? (Use the values in dollar.)

Question

Quizplus · Accepted Answer

To satisfy debt holders and equity holders, the firm needs to generate enough cash flow to cover the interest payments on the bonds and provide a return to the common stockholders.

The interest payments on the bonds are $6 million x 6% = $360,000.

The common stockholders require a 10% return on their investment, which is $13 million x 10% = $1,300,000.

So the total cash flow required before tax and interest is $360,000 + $1,300,000 = $1,660,000.

To find the amount before taxes and interest, we need to divide this by 1 - tax rate of 35%:

$1,660,000 / (1 - 0.35) = $2,553,846.

Therefore, the firm needs $2,553,846 in cash flow before taxes and interest to satisfy debt holders and equity holders. However, since the question asks for the amount before tax and interest, we need to subtract the interest payments on the bonds of $360,000:

$2,553,846 - $360,000 = $2,193,846.

Therefore, the firm needs $2,193,846 in cash flow before tax and interest to satisfy debt holders and equity holders.

The closest answer choice is C) $2,360,000, which is the best choice.

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