Question

Floundering Fish Ltd. Is an all equity firm with EBIT of $950,000 per year which will continue forever as the company pays out all earnings in the form of dividends. T-bills are currently yielding 2%; the market risk premium is 5%; the company’s tax rate is 40%; and costs of financial distress apply. Assume the market value of debt is equal to its book value. Beta of all equity firm is 0.85. What would be the value of the company if it issues $3 million in debt, with a cost of debt of 5% and a Beta of 1.6? What would be the present value of financial distress costs if the firm issues $3 million in debt ? What is the optimal capital structure: debt of 0, $2 million or $3 million?

Answer 1

Case 1 : All equity firm

As per the question:

Rf (Risk free rate of return)= 2%

(Rm-Rf) = 5%

Hence as per Capital asset pricing model : Re= Rf+ (Rm-Rf) beta

Re= 2%+ (5-2)% * 0.85

= 4.55 %

Since there is no debt . cost of capital or WACC = 4.55%

Now, Calculation of value of company

EBIT 9,50,000

Less: Tax @ 40% 3,80,000

NOPAT 5,70,000

PV of free cash flow= 570000/ 4.55 %

Value of company = $ 1,25,27,472

Case 2 : In case of issuance of debt of $ 2 million

Re = Rf+ (Rm-Rf) Beta

= 2%+ (5-2)% * 1.6

= 6.8%

Cost of Debt i.e Kd= 5%

Post tax Kd= 5(1-0.4)= 3%

Lets assume total equity = $ 1million

Kc or WACC= (2 Mn/ 2Mn+1Mn)* 3% + (1Mn/2Mn+ 1Mn)*6.8%

= 4. 2 %

Now, Calculation of value of company

EBIT 9,50,000

Less: Tax @ 40%   3,80,000

NOPAT 5,70,000

PV of free cash flow= 570000/ 4.2 %

Value of company = $ 1,35,71,428

Case 2 : In case of issuance of debt of $ 3 million

Re = Rf+ (Rm-Rf) Beta

= 2%+ (5-2)% * 1.6

= 6.8%

Cost of Debt i.e Kd= 5%

Post tax Kd= 5(1-0.4)= 3%

Lets assume total equity = $ 1million

Kc or WACC= (3 Mn/ 3Mn+1Mn)* 3% + (1Mn/3Mn+ 1Mn)*6.8%

= 3.95 %

Now, Calculation of value of company

EBIT 9,50,000

Less: Tax @ 40%   3,80,000

NOPAT 5,70,000

PV of free cash flow= 570000/ 3.95 %

Value of company = $ 1,44,30,379

Optimal capital structure is debt of $ 3 Million as the value of company is maximum in that case.