King Messi Corp. is expected to have $20 earnings before interest and taxes every year in perpetuity and a tax rate of 20%. The firm is financed with $100 in debt and the remainder with equity. The firm’s cost of debt is 5%. Its earnings after taxes are expected to be fully paid out as dividends. Based on this information, what is the total cash flow to debt and equity holders?

Answers:

16

17

18

19

20

The total cash flow to debt and equity holders is $16, calculated as the sum of the interest payments to debt holders and the earnings after taxes to equity holders.

The total cash flow to debt holders is equal to the interest payments on the debt. The interest payments are calculated as follows:

Interest payments = Debt * Interest rate

In this case, the debt is $100 and the interest rate is 5%. Therefore, the interest payments are:

Interest payments = $100 * 0.05 = $5

The total cash flow to equity holders is equal to the earnings after taxes. The earnings after taxes are calculated as follows:

Earnings after taxes = Earnings before interest and taxes * (1 - Tax rate)

In this case, the earnings before interest and taxes are $20 and the tax rate is 20%. Therefore, the earnings after taxes are:

Earnings after taxes = $20 * (1 - 0.20) = $16

Therefore, the total cash flow to debt and equity holders is $5 + $16 = $21.

Interest payments = Debt * Interest rate

In this case, the debt is $100 and the interest rate is 0.05. Therefore, the interest payments are:

Interest payments = $100 * 0.05 = $5

Earnings after taxes = Earnings before interest and taxes * (1 - Tax rate)

In this case, the earnings before interest and taxes are $20 and the tax rate is 0.20. Therefore, the earnings after taxes are:

Earnings after taxes = $20 * (1 - 0.20) = $16

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