Question

Problem #1: A firm with a normalized pretax income of $40 million, 25% tax rate, and a Total Debt/Total Capital ratio of 30%, decides to undertake a capital expansion financed by new debt. The new level of debt will raise the Total Debt/Total Capital ratio to 40% (5-percentage points above its industry average). As a result, the firm’s credit rating is downgraded by a full level (say for example, from A to B) despite being secured by specific assets. This credit downgrade raises the firm’s Weighted Average Cost of Capital (aka Required Rate of Return) from 10% to 11.5%

1. What is the value of the firm prior to the downgraded credit rating?
2. Assuming the firm’s capital expansion program will lead to a 20% increase in normalized pretax income what is the firm’s value in the aftermath of the credit downgrade?

Problem #2: How would your answer to Problem #1 change if the debt was unsecured? Specifically, what might the credit rating be under an unsecured format and how would this affect the value of the firm? Explain or provide your reasoning.

Problem #3: How would your answers to Problems #1 and #2 be affected by the percentage of insider ownership of equity and what life-cycle stage the firm is in? Explain or provide your reasoning.

Answer 1

a)

the value of the firm prior to the downgraded credit rating   

given that,

debt capital ratio = 30%, it implies that equity capital ratio = 70%

value of equity(s)= profit after taxation / weighted average cost of capital

= 40 million *( 1-25%) / 10%

= 300 million

now, value of debt (d) = 300 million *30%/70%

= 128.571 million

now, value of firm = s+d

= 300 million+128.571 million

= 428.571 million

b)

here, debt capital 40%, equity capital 60%

value of equity(s) = 48million(1-25%)

= 36million

weighted average cost of capital 11.5%

value of equity (s) = 36million*/11.5%

= 313.043 million

now,

value of debt (d) = 313.043*40% / 60%

=208.696 million

now, value of firm = s+d

= 313.043+208.696

= 521.739 million

Problem #2:

if the debt was unsecured, then due to risk factor weighted average cost of capital will increase there by value of firm decreased. credit rating will also get lowered. and expected rate of return will increase.

Problem #3:

in the above solution, initially debt 30%, and equity 70% but with the inroduction of debt capital, the value of the firm increased.

based on above solutions we can observe that the value of firm is increased, so we can say that the firm is in growth stage in its life cycle.