Question

HW#7

Case I: Capital structure theory (no tax)	Case II: Capital structure theory (corporate tax)
EBIT : $33 million Cost of equity : 14% Debt-to-Firm value : 50% Cost of debt : 10%	EBIT : $33 million Tax rate : 40% Cost of debt : 10% Unlevered cost of capital : 12%

a). In Case I, what is the WACC? And what is the firm’s value based on the assumption that EBIT is constant forever?

b). In Case I, if the debt-to-firm value decreases to 40%, what is the new firm value? What is the new WACC?   And does the cost of equity increase or decrease?

c). In Case II, if the debt were zero, what would be the firm’s value based on the assumption that EBIT is constant forever? Again, if the debt increases to $60mil., what is the present value of annual tax shield? What is the firm’s value under the assumption of infinitely constant EBIT?

d). In Case II, if the debt increases to $60mil., does the cost of equity increase or decrease? Does the WACC increase or decrease?

e). In Case I, is there an optimal debt ratio? In Case II, is there an optimal debt ratio? If so, what is that? If we consider both corporate tax and bankruptcy, is there an optimal debt ratio?

Answer 1