Corporate Finance

Does borrowing make the business worth more?

Name: Business Tutor
Address: Burnaby, BC, CA
Telephone: +1-604-916-5838
Price range: C$30–C$129

Change the debt split to see what happens to share price, earnings, risk and the cost of equity in a perfect market. Solve has 10 questions worked step by step.

Assets and claims · Step 1 of 12

Debt and equity are claims on the same business

Before borrowing: market values

Assets
Business assets	$1M
Total assets	$1M

Liabilities and capital
Equity	$1M
Total liabilities and capital	$1M

After borrowing and completing the buyback: market values

Assets
Business assets	$1M

Total assets	$1M

Liabilities and capital
Debt	$0.4M
Equity	$0.6M
Total liabilities and capital	$1M

D: market debtE: market equityV: business assets = D + E

Assets and claims · Step 1 of 12

Debt and equity are claims on the same business

Velvetcog Works is a fictional company with business assets worth $1 million and 50,000 shares before borrowing. D and E are market values, and V = D + E. Move the borrowing amount to change who owns claims on those assets.

Try it: Move borrowing down to zero, then add it back.

Borrowing for the buyback ($)$0.4M

Firm value

$1M

Debt

$0.4M

Equity

$0.6M

E = V − D = (1,000,000 − 400,000) = $600,000.

V = D + E = (400,000 + 600,000) = $1,000,000.

Debt weight = (400,000 ÷ 1,000,000) = 40%.

Check yourself

Which amounts belong in D + E when measuring firm value?

Question 1 of 10Core

Borrowing to buy back shares

All firms and numbers are fictional. Assume a perfect market: no taxes, financial-distress or trading costs; investment policy is fixed; investors borrow and lend at the firm’s rate. Cash flows arrive at year-end. Fractional shares are allowed in buybacks and personal strategies. Carry unrounded values between steps; round final per-share money to cents and other money to whole dollars, rates to two decimals if needed and betas to two decimals. Velvetcog Works starts with no debt, a market value of $1,200,000 and 60,000 shares. It borrows $480,000 and buys back shares at the original market price. Find the original price, shares bought, shares left, equity value after, price after and total firm value after. Subtract the original price from the new price. Does the share price change?

Given

All-equity firm value$1,200,000

Shares before borrowing60,000 shares

Debt borrowed and spent on the buyback$480,000

Solution

Before borrowing: market values

Assets
Business assets	$1.2M
Total assets	$1.2M

Liabilities and capital
Equity	$1.2M
Total liabilities and capital	$1.2M

D: market debtE: market equityV: business assets = D + E

Read the question and the givens first. Try the first part yourself, then press Start solving and open the working to check.

Original price

Bought; left

Equity after

Price after

Firm value after

Price gap; conclusion

Exam coming up and the cost of equity still will not sit still?

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Does borrowing make the business worth more?

Debt and equity are claims on the same business

Debt and equity are claims on the same business

Borrowing to buy back shares

Exam coming up and the cost of equity still will not sit still?

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