American Home Products

Line 1: These are the different levels of debt we are going to assess
Line 2: The EBIT is given to us
Line 3: Interest Expense: As our debt ratio rises, so does our interest expense:
In general, Interest Expense = (Value of Firm) x (D/E) x (Required Return on Debt):
  * Debt = 0.00%: Interest = (500,000) x (0) x (8.00%) = 0
  * Debt = 10.00%: Interest = (500,000) x (.1) x (8.25%)= 4,125
  * Debt = 20.00%: Interest = (500,000) x (.2) x (8.75%)= 8,750
  * Debt = 30.00%: Interest = (500,000) x (.3) x (9.25%)= 14,625
  * Debt = 40.00%: Interest = (500,000) x (.4) x (11.00%)= 22,000
  * Debt = 50.00%: Interest = (500,000) x (.5) x (12.50%)= 31,125

  * Line 4: Profit Before Taxes (PBT):
PBT = EBIT (line 2) – Interest (line 3)
Line 5: Taxes:
Note that taxes are given to us as 50%. Therefore, the taxes are calculated as such:
Taxes=(0.50)×PBT(line 4)
Line 6: Profit After Taxes (PAT):
PAT=PBTline 4- Taxes(line 5)
Line 7: Dividends:
Note that all of our remaining profits (PAT) will be paid out to share holders in the form of dividends. Therefore:
Dividends=PAT(line 6)                                                  
Line 8: Total Payments to Security Holders:
Security Holders include both share holders and debt holders. Share holders are paid in dividends and debt holders are pain in the form of interest. Therefore:
Total Payments to Security Holders= Dividendsline 7+ Interest(line 3)                        
Line 9: Cost of Debt Capital: given to us for each level of debt
Line 10: Cost of Equity Capital: given to us for each level of debt
Line 11: Market Value of Debt:
Our debt is in the form of interest paid. We are also given the cost of debt. Therefore:
              VD=Interestline 3Cost Of Debt(line 9)      
It should be noted that the interest rate is very much correlated to the cost of debt. This is why we will see that the Market Value of Debt will increase at a steady, linear pace.
Line 12: Market Value of Equity:... [continues]

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