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My teacher asked me the question today If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock.Bernie's is in the 25 percent state-plus-federal corporate tax bracket, its unlevered beta is .98, the risk-free rate is 2.5 percent, and the market risk premium is 8.5 percent.

The company's EBIT was $300 million last year and is expected to grow at a rate of 3% per year forever. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm's owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:

Background information given: Now, to develop an example which can be presented to Bernie's management to illustrate the effects of financial leverage, consider two hypothetical firms:Firm U, which uses no debt financing, and Firm L, which uses $75,000 of 5 percent debt.Both firms have $250,000 in assets, a 25 percent tax rate, and an expected EBIT of $60,000.

% Debt

rd

0%

10%

7.00%

20%

7.50%

30%

9.00%

40%

11.75%