Your best friend is in a senior position of the finance department of Teenie Tiny and you
Question:
Your best friend is in a senior position of the finance department of Teenie Tiny and you are having lunch together after a round at the golf course. The discussion gets around to the fact that Teenie Tiny will lose their tax-exempt status and your friend mentions that all the debt that the company needs will be financed using bonds with a 5 percent coupon. However, you remember that during a lecture at SMU, it was mentioned that as a company issues more and more debt, the risk for the bondholders will increase and bondholders will require coupon interest rates to increase as the amount of debt increases. You have prepared the following table to assist in answering these questions:
Value of Debt | RD | Beta | ||
EBIT | 800,000 | 0 | 5.0% | 1.392500 |
Tax Rate | 40% | 250,000 | 5.5% | 1.483015 |
T-bill Rate | 3.0% | 500,000 | 6.0% | 1.542274 |
TSX | 11.0% | 750,000 | 6.5% | 1.607016 |
1,000,000 | 7.0% | 1.678038 | ||
1,250,000 | 9.0% | 1.756303 | ||
1,500,000 | 11.0% | 1.842075 | ||
1,750,000 | 13.0% | 1.939488 | ||
2,000,000 | 15.0% | 2.047619 |
- Calculate the required rate of return for the un-levered firm.
- Calculate the market value of the un-levered firm in proposition I.
- Calculate the WACC for an un-levered firm in proposition II.
- Using the information from the table, calculate the value of the firm (proposition I), cost of equity, and the WACC (proposition II) each level of debt.
Value of Debt | rD | Beta |
0 | 5.0% | 1.392500 |
250,000 | 5.5% | 1.483015 |
500,000 | 6.0% | 1.542274 |
750,000 | 6.5% | 1.607016 |
1,000,000 | 7.0% | 1.678038 |
1,250,000 | 9.0% | 1.756303 |
1,500,000 | 11.0% | 1.842075 |
1,750,000 | 13.0% | 1.939488 |
2,000,000 | 15.0% | 2.047619 |
- Calculate the present value of distress.
Value of Debt | Value of the Firm World III | Value of the Firm World II | PV of Distress World III – World II |
0 | |||
250,000 | |||
500,000 | |||
750,000 | |||
1,000,000 | |||
1,250,000 | |||
1,500,000 | |||
1,750,000 | |||
2,000,000 |
- Graph (on 2 separate graphs) the information for proposition I and proposition II.
- Briefly explain the amount of debt the company should use as a levered company.
To maximize the value of the firm and to minimize the WACC for the firm, the unlevered firm should issue $1,000,000 of debt.
Expert Answer:
As per proposition 1 of MM the value of firm remain unchanged irrespective of the mode of financing However with the introduction of taxes we see a ch... View the full answer
