Scott Stationary Limited is an all equity company with EBIT of $850,000 per year which will continue forever as the company pays out all earnings in the form of dividends (i.e. no growth).

You must determine the optimal capital structure for this company. You have been provided with the following additional information: T-bills are currently yielding 3%; the market risk premium is 7%; the company's tax rate is 40%; and costs of financial distress apply. Assume the market value of debt is equal to its book value.

 

a) What is the value and WACC of this all-equity firm? 

b) What would be the value of the company if it issues $1 million in debt? 

c) What would be the company's Beta if it issues $1 million in debt? 

d) What would be the value of the company if it issues $2 million in debt? 

e) What would be the PV of financial distress costs if the firm issues $2million in debt?

Transcribed Image Text:

Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs $0 1 $1,000,000 $2,000,000 4% $200,000 5% 1.35 Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs $0 1 $1,000,000 $2,000,000 4% $200,000 5% 1.35

Answer rating: 100% (QA)

a Wacc of all equity frim cost of equity as it has only equity and no debt By CAPM cost of equity Ri... View the full answer