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Question 6 Visio & Co, an ungeared firm, has expected earnings before interest and taxes of 2million a year. Visio's tax rate is 19%, and the market value is V = E = 16 million Company's stock has a beta of 1.6 and the risk-free rate is 3%. Assume that E(Rm) - Rf = 8%. Management is considering the use of debt; this debt would be issued and used to buy back stock and the size of the firm would remain constant. The default free interest rate on debt is 6%. Because interest expense is tax deductible, the value of the firm is likely to increase as debt is added to the capital structure, but there would be an offset in the form of the rising cost of bankruptcy. The firm's analysts have estimated that the present value of any bankruptcy cost is approximately 10million, and the probability of bankruptcy will increase with gearing according to the following schedule: 5 Value of Debt (in :) Probability of Failure (in%) 2,000,000 5.00 4,000,000 8.00 6,000,000 15.00 8,000,000 20.00 9,000,000 24.00 10,000,000 28.00 Required a. Using the adjusted present value approach (APV), calculate the value of geared firm, when bankruptcy costs and tax benefit are considered? (Marks - 7) b. What will the value of Visio & Co, be at this optimal capital structure? (Mark -1) Question 6 Visio & Co, an ungeared firm, has expected earnings before interest and taxes of 2million a year. Visio's tax rate is 19%, and the market value is V = E = 16 million Company's stock has a beta of 1.6 and the risk-free rate is 3%. Assume that E(Rm) - Rf = 8%. Management is considering the use of debt; this debt would be issued and used to buy back stock and the size of the firm would remain constant. The default free interest rate on debt is 6%. Because interest expense is tax deductible, the value of the firm is likely to increase as debt is added to the capital structure, but there would be an offset in the form of the rising cost of bankruptcy. The firm's analysts have estimated that the present value of any bankruptcy cost is approximately 10million, and the probability of bankruptcy will increase with gearing according to the following schedule: 5 Value of Debt (in :) Probability of Failure (in%) 2,000,000 5.00 4,000,000 8.00 6,000,000 15.00 8,000,000 20.00 9,000,000 24.00 10,000,000 28.00 Required a. Using the adjusted present value approach (APV), calculate the value of geared firm, when bankruptcy costs and tax benefit are considered? (Marks - 7) b. What will the value of Visio & Co, be at this optimal capital structure? (Mark -1)

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