Question

Under the assumptions of Modigliani and Miller’s original paper, a firm’s stock price will be maximized at 100% (debt, equity) . Signaling theory implies that a firm with extremely favorable prospects will be more likely to issue (stock, debt) to fund any new projects. When a firm announces a new stock offering, the price of its stock will usually (increase, decrease)   . When information is (asymetric, symetric)   , managers have more information about a firm’s prospects than investors do.

Drugal Brewing Co. currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm’s unlevered beta is 1.20, and its cost of equity is 11.40%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.40%. The risk-free rate of interest (rRFrRF) is 3%, and the market risk premium (RP) is 7%. Drugal Brewing Co.’s marginal tax rate is 35%.

Drugal Brewing Co. is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table.

D/A Ratio	E/A Ratio	D/E Ratio	Bond Rating	Before-Tax Cost	Levered Beta (b)	Cost of	WACC
				of Debt (rdrd)		Equity (rsrs)
0.0	1.0	0.00	—	—	1.20	11.40	11.40
0.2	0.8	0.25	A	8.10	?	12.80	11.29
0.4	0.6	0.67	BBB	8.50	1.72	15.04	?
0.6	0.4	1.50	BB	10.90	2.37	?	12.09
0.8	0.2	?	C	13.90	4.32	33.24	?

Answer 1

Answer a.

Under the assumptions of Modigliani and Miller’s original paper, a firm’s stock price will be maximized at 100% debt. Signaling theory implies that a firm with extremely favorable prospects will be more likely to issue stock to fund any new projects. When a firm announces a new stock offering, the price of its stock will usually decrease. When information is asymmetric, managers have more information about a firm’s prospects than investors do.

Answer b.

Case B:

Levered Beta = Unlevered Beta * [1 + (1 - tax) * (D/E)]
Levered Beta = 1.20 * [1 + (1 - 0.35) * 0.25]
Levered Beta = 1.20 * 1.1625
Levered Beta = 1.40

Case C:

WACC = (D/A) * Before-tax Cost of Debt * (1 - tax) + (E/A) * Cost of Equity
WACC = 0.40 * 8.50% * (1 - 0.35) + 0.60 * 15.04%
WACC = 11.23%

Case D:

Cost of Equity = Risk-free Rate + Levered Beta * Market Risk Premium
Cost of Equity = 3% + 2.37 * 7%
Cost of Equity = 19.59%

Case E:

D/E Ratio = (D/A) / (E/A)
D/E Ratio = 0.80 / 0.20
D/E Ratio = 4.00

WACC = (D/A) * Before-tax Cost of Debt * (1 - tax) + (E/A) * Cost of Equity
WACC = 0.80 * 13.90% * (1 - 0.35) + 0.20 * 33.24%
WACC = 13.88%