Question

Capital Structure Analysis

Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company's EBIT is $10.58 million, and its tax rate is 35%. Pettit can change its capital structure either by increasing its debt to 55% (based on market values) or decreasing it to 45%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 9% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change.

The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of equity, rs, is 14%. If it increases leverage, rs will be 16%. If it decreases leverage, rs will be 13%.

Present situation (50% debt):
What is the firm's WACC? Round your answer to three decimal places.
_______%
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ ______million

55% debt:
What is the firm's WACC? Round your answer to two decimal places.
______
%
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ ______ million

45% debt:
What is the firm's WACC? Round your answer to two decimal places.
_______

What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ ______million

Answer 1

Considering the Market value of the company remaining constant in each debt scenario we find out the debt values as shown in the following screenshot.

Total corporate value is the intrinsic value that conveys that if a particular capital structure produces a particular EBIT, what is the value of the firm. Capital structure impacts the WACC, which in turn impacts the intrinsic value.

Keeping EBIT constant, and after the calculation of WACC, the calculation of intrinsic value is shown in the following screenshot