Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: How much does Dynamo currently pay in 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, $26.25
B) $26.25, $42
C) $160, $37.50
D) $37.50, $160

Question

Quizplus · Accepted Answer

According to M&M Proposition 1, the value of a firm is independent of its capital structure, and the cost of equity increases with leverage. Therefore, the interest paid by Dynamo should remain the same irrespective of the capital structure.

Current interest paid by Dynamo = Debt * Cost of debt = 0.25 * $150 * 0.07 = $2.625

After restructuring, the proportion of debt will increase to 50%, and hence the interest paid will be:

Interest paid by Dynamo after restructuring = Debt * Cost of debt = 0.5 * $150 * 0.07 = $5.25

Therefore, Dynamo currently pays $2.625 in interest, and it will have to pay $5.25 after the restructuring. Hence, the correct answer is B.

Dynamo Company Produces Annual Cash Flows of $150 and Is