Question

As a firm takes on more debt, its probability of bankruptcy_______. (Increases or Decreases) Other factors held constant, a firm whose earnings are relatively volatile faces a________(Greater or Lower) chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use_______(Less or More) debt than a more stable firm. When bankruptcy costs become more important, they __________(Increase or Reduce) the tax benefits of debt.

Green Goose Automation Company 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 1.25, and its cost of equity is 11.75%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.75%. The risk-free rate of interest (rRFrRF) is 3%, and the market risk premium (RP) is 7%. Green Goose’s marginal tax rate is 35%.

Green Goose 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/Cap Ratio	E/Cap Ratio	D/E Ratio	Bond Rating	Before-Tax Cost of Debt (rdrd)	Levered Beta (b)	Cost of Equity (rsrs)	WACC
0.0	1.0	0.00	—	—	1.25	11.75%	11.75%
0.2	0.8	0.25	A	8.4%	A.) 1.162 B.) 1.453 C.) 1.671 D.) 1.380	13.171%	11.629%
0.4	0.6	0.67	BBB	8.9%	1.792	15.544%	A.) 10.476% B.) 11.640% C.) 14.550% D.) 12.840%
0.6	0.4	1.50	BB	11.1%	2.469	A.) 25.354% B.) 20.283% C.) 24.340% D.) 17.241%	12.442%
0.8	0.2	A.) 2.800 B.) 4.00 C.) 4.200 D.) 3.400	C	14.3%	4.500	34.500%	A.) 14.336% B.) 15.770% C.) 10.752% D.) 16.486v

Answer 1

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