Question: Problem 3 (32 marks) Your best friend is in a senior position of the finance department of Teenie Tiny and you are having lunch together
Problem 3 (32 marks)
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 |
- 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. (16 marks)
| 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 |
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